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Hello Fools,

I've mostly lurked here and on the COMS board for the last few months. I created what follows as "homework" for the Rule Breaker seminar that is now winding down. I thought it would be of obvious interest on this board (and to the COMS and RB Companies boards, where I'm also posting it). I'd love to hear your comments, criticisms, etc, but please be gentle - I'm new to this.

A note of disclosure: I invested in 3-Com back in September and October in anticipation of the spin-off of Palm to 3-Com shareholders. I had just finished reading "Rule Makers, Rule Breakers," and thought Palm had all the earmarks of a Rule Breaker. The extra "due diligence" of the last few weeks has shaken my confidence a bit, but I'm still holding my COMS shares.'s a review my thoughts on how Palm stacks up against the official Rule Breaker criteria with a little help from the...(ahem)...Magic 8 Ball! Also, note that the stock price and market cap statistics are from Monday.

The top dog and first mover in an important, emerging industry

"It is decidedly so."

An important emerging industry? For those few who don't know (and according to tonight's MF poll, that would be only 2% of those visiting the Fool), Personal Digital Assistants (PDAs), are small pocket sized computer devices that feature pen-based input, store and manipulate mostly personal information (like names, addresses, phone numbers, calendars, to-do lists, memos and much more) and synchronize that data with a desktop personal computer (to applications like MS Outlook and Lotus Organizer).

In the seminar, David Gardner suggested other benchmarks of an emerging industry: huge growth curve, wide scope and possibilities beyond that.

The PDA market features a huge growth curve: The IDC Corporation estimates that annual worldwide sales of PDAs will increase from approximately $1 million to $14 million by 2003, an annualized growth rate of about 55% over a period of seven years.

It also has Wide Scope., "drilling down in ways that really matter into the lives of millions of people around the world." By the year 2003, projections are for 35 million personal digital assistants worldwide. That means 35 million people around the world keeping their appointments, address books and other personal data on small palm sized computers in just three years.

And if that's not enough, consider tonight's Polling All Fools feature. Of more than 4000 Fools that responded, 64% own a PDA, 56% use it at least daily and 12% say their PDA "is more critical to my daily life than water."

Finally, the PDA market is either morphing into (or colliding with, depending on your point of view) the market for wireless phones and Internet devices. As such, the potential for possibilities beyond the PDA market is staggering. Projections for 2003 are for 330 million smart phones to by shipped and for 335 of the projected 1 billion cellular customers to be using a smart phone's enhanced display, data-entry capabilities and storage to access the Net, run server-assisted apps and use location-based services.

A top dog and first mover? According to the International Data Corporation, in 1998 Palm had a market share of 68% of the worldwide personal companion handheld device market. If that doesn't make Palm the top dog of PDAs, I'm not sure what would.

In the seminar, David Gardner suggested some other yardsticks, including comparing market cap, sales and earnings to competitors and looking for "buzz" in industry rags.

Market Cap is a difficult measure for PALM, since the current official market cap- $31 billion - is based on the value of the 4% of shares currently trading as "PALM" (the 93% still controlled by 3-Com appear to have a lower value - more on that below). However, even if we halve Palm's market cap, it would still be larger than any other company listed in the "computer peripheral industry" by (thanks to Harold, a.k.a. ConsultHR, for this observation). Comparison to competitors in the PDA industry are difficult, because most are either huge companies with many other products or small private companies).

Comparisons between PALM and its competitors are also difficult in terms of sales and earnings, for the same reasons. However, it's worth noting that Palm's sales more than doubled to $566 million in '99, earnings grew seven-fold (from $4.2 million to $29.6 million, and gross margins are 44% and rising.

Want more evidence that Palm is a top dog in PDAs? It's hard to pick up any computer industry rag and not see a photo or article featuring some new application coming to market on the PALM. The buzz is everywhere. And not just buzz - incredible buzz.

Sports brand focus, with the potential of becoming a household name

"As I see it, yes."

Palm is not quite yet as big a brand name as Coca-Cola, but "brand focus" is clearly a part of its strength. I'd argue that "Palm Pilot" is a brand name that we use to describe a product much like "Kleenex" and "Band Aids."

David Gardner suggested a word association game to judge top dog status. Tell your friends the industry, and see which brands they associate with it. I'd argue to play the word association game in reverse. Ask your friends what a "PDA" is, or even a hand-held computer, and they will probably look at you funny. But describe what it does, and they'll probably say, " mean a Palm Pilot."

The strength of the Palm brand is the reason it currently generates gross margins of 44%.

[And apparently David Gardner see it this way too. He singled out Palm and Oracle as the two best brands among those nominated as Rule Breakers in the seminar. Not the best Rule Breakers, mind you, but the two most prominent brand names].

Has a sustainable advantage founded on a strong business model

"Signs point to yes."

This is the nub of the argument for Palm as a Rule Breaker. No one can deny that Palm currently rules the PDA market. The question is whether their advantage is sustainable, and on that score there is room for debate.

According to the prospectus for the Palm IPO, Palm currently says that "substantially all [of its] revenues to date have been generated from sales of our handheld devices and, to a lesser extent, peripherals and accessories." However, Palm's prospects for continuing growth depend on their ability to make money from two new sources: (1) subscriptions to its wireless Internet access service and, (2) much more important licensing of the Palm platform to other makers of PDAs, wireless Internet devices and smart phones.

The decision by Palm to license its operating system (OS) is a huge risk for Palm. Doing so facilitates Palm's "tweening" as manufacturer of PDA's. The Palm OS holds the essence of its appeal to users. By licensing the Palm OS, a competitor like Handspring can offer Palm "clones" - PDA's with all the functions and feel of a Palm Pilot at a lower price.

Of course, as with any risk, the decision to license the OS brings with it incredible opportunity. Palm is poised to become the OS of choice for PDA and smart phones, a business model that has been quite successful in the PC market (to say the least) for a certain software company in Seattle. Consider what David Levin, CEO of Psion (a Palm competitor) says about mobile phones: "Every handheld sold in history equals no more than one good week's worth of cellular phone sales."

What is Palm's strategic control in the competition to become the OS for handhelds? Start with the strong brand loyalty of its base of 4 million users. The add the 7,000 software applications are currently available for the Palm OS, and 40,000 independent developers now writing software for the Palm OS and you have what the folks at Palm call the "Palm Economy." It is this base of applications and developer support that has allowed Palm to negotiate alliances with Motorola, Qualcomm, Nokia, Ericsson, Sony, AOL. The deal with Nokia is perhaps the most interesting - Nokia is working to make the Palm OS work as the "top layer" of a 32 bit operating system. [Good summary of the case for Palm:
Also see the links at:]

Of course, there is considerable debate on this question. A recent article in Barrons argues that the "smart" wireless phones will soon provide all the functions of a handheld for less money without the Palm OS. The article argues that the Palm OS is becoming outdated, that G-3 smart phone standards such as Wide Area Protocol (WAP), Bluetooth and the EPOC Symbian operating system will undermine Palm's strategic control
[see ]

Obviously, there is great risk here. Virtually all of Palm's current revenue and earnings come from PDA sales. The licensing business model is unproven, and Palm's chief competitor in the hand-held market is none other than Microsoft itself - not exactly an "inept competitor." Still, the strength of Palm's brand loyalty and the huge base of existing applications and developer support gives it a big advantage. Why else would Nokia, Motorola, Sony, Motorola, et. al. line up to make deals for the Palm OS?

Is run by people you admire

"Outlook not so good."

Palm's leadership is a big question mark - and perhaps its Achilles' Heel as a Rule Breaker.

The two visionaries who conceived of and created Palm Computing, Jeff Hawkins and Donna Dubinsky, left Palm last year to create Handspring, a new company offering a new hand-held computer that licenses the Palm OS and competes with the Pilot. Their departure is widely reported to friction with the 3-Com management who continue to play a significant role in Palm Inc.

The new CEO of Palm is Carl Yankowski, who calms to Palm after serving as CEO of Reebok and, before that, president and COO of Sony, helping to bring to market the DVD, digital imaging and the VAIO computers. Yankowski has degrees in engineering and management from MIT. He is clearly brings strong backgrounds in management, marketing and technology to Palm. However, he has been criticized as being bland, "sort of a mild-mannered, Clark Kent type with a slide rule," who at Sony " was basically a puppet for the Japanese.",6061,2403378-2,00.html)

Might Yankowski make a clean break from the 3-Com culture that drove away Hawkins and Dubinsky? Doubtful. The three top managers under Yankowski are all long term 3-Com veterans. These include President Alan Kessler, a "13 year veteran" of 3-Com, VP/CFO an "11 year veteran," and VP Mark Bercow (From corporate bios on Palm's four member board of directors includes 3-Com CEO Eric A. Benhamou. In one of his few on the record interviews, Yankowski said, "I want to partner strongly with [Alan Kessler]--I'm not going to bring change for the sake of change. I'm going to look at what fine tuning is appropriate to the organization."

Palm will definitely need strong dynamic leadership to succeed, especially given the need to transition so quickly from a business model based on PDA sales to a model dependent on licensing revenue. It's the kind of challenge we can imagine a Bill Gates rising to.

Can Carl Yankowski meet the challenge? I do not feel comfortable condemning him on the basis of a few scattered press clippings, but these first signs are not exactly the most hopeful. Time will tell. For now, I find myself wishing that a prominent investment news source (like say...the Motley Fool) would do an in-depth interview with Yankowski (are you listening Dave and Tom?) ; )

Has had excellent past price appreciation

"Reply hazy...ask again later."

Palm has been publicly traded for only two weeks, and as such, IBD and other sources do not yet report a relative strength measure for it. I would argue that it meets this criterion because a few years of price appreciation occurred for Palm over a day or two. It's IPO price was raised from $16 to $38 dollars the day before the IPO. And Palm is currently trading at nearly double that price ($69 1/4). Excitement over the Palm IPO also drove the price of 3-Com from the mid $20s to Monday's close of $68 9/16.

Palm's immense market cap ($31 billion as measured by the price of PALM), is also evidence of the value placed on this stock by Wall Street.

Of course, Palm's performance looks disappointing if you start from its opening price of about $145 and track it to today's close of $69 1/4. I'm not sure this is a fair measure, given that the $145 price was the result of IPO & day trader lunacy. But relative strength as measured by IBD is one of the criteria, an who can say what the RS will be a year from now.

Has recently been called overvalued in the media

"It is decidedly so."

Finding someone to suggest that PALM is overvalued is not that hard. Here's one from the March 8, Mercury News Herald, suggesting several reasons for the discrepancy in value between Palm and 3-Com.:

"A) Palm is overvalued. If the current market price for 3Com is really an accurate predictor of Palm's value, then Palm's stock has a way to fall. In fact, you could argue that Palm stock could be worth as little as $35 or $36 per share."

The problem is that Wall Street currently seems to have two values for Palm Computing. One is based on the 4% of Palm shares now being traded, and the other on the 93% of Palm still held by 3-Com, and the two values are currently waaaaay out of whack. Here's the simple version. The official market cap of Palm, based on the current value of PALM stock, is $32 billion - this is more than the value of 3-Com itself ($23 billion)!!!

Do a little extrapolation (which I'm glossing over to keep this short) and the "value" of Palm Computing is either $69 (the price of PALM) or about $30-35 (the price of Palm extrapolating from the current price of 3-Com). So either Palm really is "overvalued" at the moment compared to 3-Com, or 3-Com is "undervalued" compared to Palm, or both. (This is a BIG source of debate on the PALM and COMS message boards - if you're interested do check it out).

The Bottom Line: Is PALM a Rule Breaker?

The best answer may be: "Ask Again Later..."

All Rule Breakers are inherently risky, but as the discussion of Palm's dual "valuation" shows, buying PALM shares right now is especially risky. A lot of this risk will be lessened within six months, after 3-Com completes its spin-off. Right now, with only 4% of Palm currently trading, which makes it an odd stock to follow.

If you believe in Palm, 3-Com looks like a better bet right now (although there's extra risk there too - again, see the message boards for details). Or you can just wait until after the spin-off is complete and check out Palm again.

In six months or so, we may have a better sense of Carl Yankowski and Palm leadership. Right now, PALM is still in the one month "silent period" imposed by the SEC on companies putting out IPOs. In six months or so, we will also know a lot more about how serious Nokia, Sony, Motorola et. al. are about marketing smart phones with Palm interfaces.

I still think the potential for Palm is tremendous. Imagine what might have become of Apple Computer if they had decided to license the Mac operating system rather than focusing on PC sales. Of course, that analogy raises the spectre of Microsoft doing to Palm what it did to, um, well...Apple.

One credit to 3-Com and Yankowski is that they are not repeating the mistakes Apple made 15 years ago. Time will tell how well they do.

Foolishly yours,

FYI - My Other Posts (and I'm not sure if non RB Seminar participants can access these)

Lesson 2 - The handheld-PDA industry #1459

Lesson 3 - Palm Inc - the top dog and first mover #1460

Lesson 4 - Carl Yankowksi #1476

Lesson 5 - Palm's business plan #1497
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