Palm Incorporated

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Palm Incorporated

• Matthew F. Soccoli
• Short Fund Manager McIntire Investment
  Institute
  
• October 7, 2003

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Company Mission

• Focus is on creating devices handheld devices
  that manage and access information rather than
  creating and editing documents
  
• Simple, Wearable, Expandable, Mobile

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Brief History

• 1996 Palm Pilots introduced under U.S.
  Robotics
  
• December 1997 Palm Licenses O.S.
• May 1997 Purchased by 3Com
• March 2000 IPO / spin-off from 3Com
• January 2002 20 million units sold
• June 2003 Handspring Merger Announced

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Current Corporate Structure
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Revenues in Millions
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Proposed Corporate Structure
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Product Line

• Tungsten Series
• Zire Series Palm Series

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New Products

• Tungsten T3
• Possible compatibility issues with SD
• Tungsten E
• Zire 21
• (Post Merger) Handspring Treo

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Investment Thesis

• Palm is not going out of business, But
• Palm is losing market share in a shrinking market
  
  
• Financial Difficulty in Producing a Profit
• Pending litigation can potentially cause serious
  financial problems
  
• Stock price has been inflated recently by news
  rather than fundamental data
  

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Palm is Losing Market Share

• Pocket PCs that run Microsoft CE have emerged
  as a serious competitor
  
• 71 to 57.7 Market Share in US
• 40 of Global Market
• New users are trying Microsoft Pocket PCs
• Old Palm users are switching to Pocket PCs
• Few are switching to Palms

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Pocket Pcs

• Recent price cuts entice switchover
• The wave of the future
• Most new users get Pocket PCs
• Traditional Windows feel - includes Word, Excel,
  Outlook
  
• Toshiba, HP, Compaq, Gateway, Dell, are a few
  Pocket PC manufacturers
  
• Gateway and Dell just got into the market and
  chose Pocket PC platform

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Handheld Market is not growing

• Palm Software has been on over 30 million
  handhelds sold
  
• Many people purchase them and stop using them
• You can get most handhelds 1/3 of the price at
  Pawn Shops
  
• Many consider them as gadgets
• Palm executives avoided questions on handheld
  growth on Sep 18th conference call, one did not
  comment, the other said it would be hard to
  determine if growth could be either single or
  possibly double digits

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But suprisingly

• News came out last week that Palm expected to see
  growth in Corporate business This only makes up
  10 of revenues.
  
• Just off this report, in two days the stock went
  up over 10

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Disruptive Technologies

• Can further weaken handheld market in the long
  term
  
• PDA/Cellphones
• Tablet PCs
• Blackberry Email reading devices

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Financial Troubles

• Earlier in the year Palm introduced Tungsten and
  Zire series Palms
  
• Zire has been the best selling handheld of all
  time yet in FY03 Q4 and in FY04 Q1 both
  showed operating losses.
  
• How can they make a profit when they dont even
  after the best selling handheld was introduced
  
• The only recent profitable quarters have been
  during the holiday season, yet still they
  produced no operating cash flows

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Not Seeking to Improve Margins

• Hardware 28.1, Software 89.9 - CFO stated they
  are in the target range
  
• Handsprings margins have been shrinking and they
  are also losing money why are they buying
  companies that are losing money?
  
• Only positive cash flow is coming from issuing
  new stock and diluting their shareholders
  shares
  

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Pending Litigation

• Xerox v. Palm Over graffiti technology used in
  Palms. Xerox claims patent infringement on its
  Unistrokes technology. Has been going on since
  1997. All but a few of the most recent models
  use this older graffiti technology(T3, C, E, Zire
  71 21)
• Numerous class action lawsuits Claiming
  deceiving marketing practices
  

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Xerox v. Palm Timeline

• April 97 Started against 3com
• Jan 99 US Patent office granted request for
  examination of Unistrokes validity. They then
  confirmed the validity of all 16 claims.
  
• June 00 A judge narrowly interpreted the claims
  and found no infringement
  

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Xerox v Palm (contd)

• Oct 5, 2000 Court of Appeals reversed the
  finding and sent the case back to the lower
  court
  
• Dec 20, 2001 District Court granted our motions
  on infringement and for finding validity thus
  establishing liability
  
• Palm appealed, Xerox tried to move for a trial on
  damages and an injunction
  
• 50 Million dollar bond required to Xerox until
  trial
  
• Jan 2003 Palm decided to stop including
  graffiti in new operating systems

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Xerox v Palm (contd again)

• Feb 2003 Court of Appeals affirmed infringment
  on the patent and stated Xerox could get an
  injuction if the validity of the patent is
  favorably determined
• Remand procedure limited discovery continued
  through September
  
• Hearing argument scheduled for December 10th, 2003

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Why Palm will lose

• They have stopped using graffiti and created new
  graffiti software to use in their newest brands
  that they plan on keeping
  
• Palm separated Palm source from Solutions Group
  in January of 2002, after the ruling
  
• They have plans on how they will handle the
  financial burden, palm solutions group will take
  a one time charge and Palm Source will have to
  pay royalties. If they werent losing they
  wouldnt talk about this

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Future Implications

• Injunction could be called on all Palms that
  carry Graffiti software by the time this
  happens there might not be any currently for sale
  that have it.
• Substantial Punitive Damages on the 20 million
  devices with palm software that have graffiti,
  and future royalties

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Worst Case Scenario

• In Palms 10k for 2003, they stated Results of
  operations and financial condition would be
  significantly harmed and we may be rendered
  INSOLVENT
• Insolvent a firm that is unable to pay debts
  on the way to bankruptcy
  

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Recent Run up in Stock Price
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The Past 3 months
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Investment Risks

• Handspring Merger can be successful synergies
  can be created but handspring is also losing
  money and has shrinking margins
  
• Palm could win Xerox case not very likely given
  actions they have taken to soften the financial
  blow. Even if they won it wouldnt necessarily
  affect the price up
• Success in the new line of products during the
  holiday season going into the season, august
  showed disappointing results
  
• Large cash position 8.40 per share

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Valuation

• There should be a margin of safety in the value
  determined through research and the current
  market value
  
• Target Share Price (in process)
• WACC 18.8 - Financed primarily through Equity

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Key Financials

• Share Price (as of this morning) 21.74
• Market Cap 689 M
• Shares outstanding 31.1 M
• Short Interest 9.40
• Cash 267 M
• Cash Per Share 8.40
• FY 03 Ebitda -177 M
• FY 04 Predicted Loss 28.7 M
• Q1 - 04 Actual Loss 21.7 M

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Research Overview

• Current News, Earnings Conference Calls
• Interviewing Palm customers, Pocket Pc Customers
• Interviewing sales associates at Circuit City,
  Staples, Office Depot
  
• Calling Xerox IR Department
• Reading Palms 10ks and 10qs Also Xeroxs

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Timeline

• October 28, 2003 Shareholders vote on
  Handspring Acquisition and PalmSource Spin-off
  
• December 15-20, 2003 Palm Q2 FY04 earnings
  report on holiday sales quarter
  
• December 20, 2003 Hearing on Xerox v. Palm
  revisited by District Court
  

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Recommendation

• Complete valuation to determine value
• Follow closely any news on Xerox litigation and
  Handspring merger
  
• Short Palm at a point where a margin of safety
  exists between the determined value and market
  price. Cover around a share price of 10 based on
  current information.
• Depending on the lawsuit w/ Xerox this could
  change very rapidly
  
• Palm will not go out of business anytime soon

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Questions?