Has Palm Lost Its Grip? Its ubiquitous gadget has become a pop icon. But that may not be enough to pull Palm through its slump.
By John Simons

(FORTUNE Magazine) – I've seen the best minds of my generation in thrall to their Palm Pilots--Prada pump-shod hipsters standing on Greenwich Village corners, searching silvery Palms for guidance on all-night tapas bars; executives achieving order amid the chaos of the morning A train, sitting jackknifed over green-hued screens, scribbling God knows what; coffeeshop poets aiming Palms at one another, gunslinger style, swapping verses across infrared beams.

Heck, if Allen Ginsberg were alive today, he might have written "Howl" on a Palm. More than a mere personal organizer, the Palm in five short years has become a pop icon. At once embodying late-'90s techno-fetishism, a work-is-play ethos, and the public's unceasing quest for personal improvement, Palm Inc.'s sleek, high-end version, the $299 Palm V, is destined for a place in the Smithsonian. It took just 18 months for the original Palm Pilot to sell one million units, thereby surpassing the IBM personal computer, the Sony Walkman, the color television, and the cell phone in rate of consumer acceptance. Some 13 million people now own a Palm-branded device.

Palm Inc.'s debut on the financial market was no less spectacular. When the company went public, on March 2 of last year, shares initially priced at $38 rose as high as $165 before settling in at $95. By day's end Palm had a market value of $53.4 billion, nearly double the valuation of the $28 billion company that had bought it in 1997 and had now spun it off: network-equipment manufacturer 3Com. Investors saw nothing but promise. The devices and the minimalist software that powered them represented a new kind of computing built on simplicity, an alternative to the aggravating complexity of Microsoft's Windows. The Palm approach didn't concern itself with chip processing speed and hard-drive capacity. No hourglasses while programs loaded. No crashes. The Palm just made life easier. A $1-billion-a-year company was born.

It's ironic that a company known for helping people plan and schedule could be so ham-handed in managing its own affairs, but such is the case with Palm. Business realities apply even when your product is a pop icon. Bungled product launches, increasing competition, and a souring economy have all conspired to loosen Palm's grip on the market it helped shape. And the company's long-term obstacles are daunting. Its closest rival, Handspring, has become more innovative than Palm. Its CEO has yet to prove himself, after 18 months on the job. Its operating system is running out of steam. And Microsoft wants its market.

The most immediate concern for Palm is its vanishing growth. Last fall a slowdown seemed implausible, especially when Palm's Christmas season sales jumped 102% over the previous year's. But the economic slump hit hard, making January and February cruel months on the sales floor. The sudden dip caught executives flat-footed. "The first few weeks, I would keep saying, 'Two data points don't make a trend, one month doesn't constitute a trend,' " says Palm marketing chief Satjiv Chahil. "After five, six weeks, I'm going, 'Yikes, people are holding on to their wallets a little harder.' " Palm managed to come out of the three-month period ended in March with revenues of $471 million, up 73% over the previous year's. But on March 27, Palm was forced to caution that revenues for the current quarter would be flat compared with those of the same period last year, and that the company would record an operating loss of about $80 million. Shares of the stock fell 48% on the announcement, to $7.44. The price has hovered near $10 since early April. "We missed the turn," admits chief financial officer Judy Bruner.

Palm's response only made matters worse. To soften up consumers, Palm began offering rebates and discounts. But in March the company hurt itself by announcing plans to have two new high-end units in stores by early May--the m500, a cousin to the famous Palm V, and the m505, a similar device with a color screen. Sales of the Palm V immediately fell. Unfortunately for Palm, by mid-May the new models were only beginning to trickle into stores. As a result, consumer purchases shifted to low-end units; Palm offers everything from the entry-level m100, which retails for about $150, to the $399 wireless Web-enabled Palm VIIx. The price of the company's average sale has dropped from $260 in May 2000 to about $197 this March.

Palm's otherworldly profit margins have shrunk too, from 39% a year ago to 32% today. The company recently warned that it expects margins to shrink to 25% this summer. While those figures aren't terrible, some industry watchers see PC-like margins in Palm's future--and for PCs, 10% to 12% is considered a windfall. "Why should a Palm device be any different from the PC?" says Salomon Smith Barney financial analyst Richard Gardner. "We can't help but think that margins are going to continue to slide."

Like other high-tech companies today, Palm is also choking on inventory. Last year the company struggled to meet demand for its gadgets. In November executives decided to solve that problem by signing a handful of long-term deals that guaranteed a steady supply of components. The contracts locked Palm into high purchase volumes that it doesn't necessarily need now. Despite another round of price cuts, Palm's inventory pileup could surpass $300 million by the end of June, which will hurt sales of new products and force the company to burn through roughly half of its available cash this quarter. Palm may also have to take a write-off.

Palm will have a tough time correcting those near-term missteps, in part because its role in the marketplace has changed from lead innovator to also-ran. In 1998, fed up with 3Com's limited vision for the handheld maker, Palm founders Jeff Hawkins and Donna Dubinsky resigned. Hawkins had been designing handheld computers since the late 1980s and was the brains behind the original Palm Pilot, the Palm V, and the wireless Palm VII. Since Hawkins' departure, Palm has yet to release a single device that hadn't been conceived by its former CEO. Even the m500 and the m505 are mere revisions of the Palm V. Within weeks of exiting Palm, Hawkins and Dubinsky founded Handspring. The company introduced its flagship Visor 14 months later and won a 21% market share in little more than a year, helping knock Palm's share down from 83% to 63%.

Handspring leapt forward with new ideas as well. The Visor carries an expansion slot to which users can attach gadgets that turn the tiny computer into an MP3 player, a camera, or even a cell phone. Some 50 third-party attachments now exist for the device. Along with other makers of handhelds, Palm has added an expansion slot to its newest models, but few attachments are available yet.

The Visor's success isn't an unalloyed loss for Palm. Handspring licenses the Palm operating system, so Palm makes about $9 in royalties on every Visor sold. But it's hard to see how Palm will replace the revenue it's losing from Handspring's cannibalization of the market. Licenses to Handspring and other handheld makers account for only about 2% of Palm's overall revenues.

With Hawkins and Dubinsky long gone, the man in charge at Palm is CEO Carl Yankowski, who so far seems to be relying on philosophy as much as on strategy. There's a mantra often repeated around the Palm offices: "the Zen of Palm." The phrase is as hard to define as the meaning of life, but Palm staffers say it is a guiding principle for the company's only-the-essentials approach to products. No one personifies the Zen of Palm more than Yankowski, who took over the company in December 1999. Yankowski arrived after a brief stint as CEO of Reebok Unlimited but is best known for driving Sony Electronics into new markets, including personal computers, DVD players, and digital imaging, with mixed results. Yankowski is a tall, husky man with a pilot's license and seven patents to his name. He'd be imposing if not for his calm, deliberate manner, which is reflected in his unworried attitude toward business.

Yankowski's long-term objective is to keep Palm at the center of what he calls the Palm economy, based largely on the ubiquity of the Palm operating system. He is quick to point out that the system resides on more than 90% of handhelds sold. "Handspring is a worthy competitor, and we try to respond to them," says Yankowski. "We are delighted to have them as a licensee inside the Palm economy rather than working exclusively with Microsoft." As the Palm economy grows, Yankowski argues, so grows Palm. Hence he claims not to fret about Handspring's market surge.

But Palm's relationship with its biggest licensee is a tenuous one. Palm's engineers are working on Palm 5.0, a major revision of the operating system. Palm 5.0 will run more powerful chip sets, but it will also require device makers to revamp their hardware around it. Handspring recently signed a contract to use the Palm OS for another eight years, but the deal doesn't bar it from contracting with makers of other operating systems, like Linux and Microsoft's PocketPC. Says Handspring co-founder Dubinsky: "We are happy with the Palm OS. At the same time, we are not exclusive. If we felt there was a substantial functionality problem or if there was something we couldn't do that we wanted to do with it...we never say never."

Microsoft would be only too eager to enlarge its minuscule footprint in the handheld-device market. Palm rivals Compaq, Hewlett-Packard, and Casio, all of which make devices powered by Microsoft's comparatively bloated operating system, garner just 8% of handheld sales. Says Microsoft Mobility director Phil Holden of his company's initial forays into handheld software: "We mucked it up royally." He now argues that Microsoft is on the right track. Holden's shop has the second-largest research and development budget on the Redmond, Wash., campus. That's $300 million--just for R&D. (The top-funded project is the X-box, Microsoft's answer to Sega and Nintendo.) The crowning glory of this effort is the Stinger, a combination cell phone and personal organizer. Mitsubishi and Samsung already manufacture the device, and wireless carriers Vodafone in Europe and VoiceStream in the U.S. have committed to rolling out the Stinger this year.

Palm has yet to parry Microsoft's thrust into the hybrid-device market. Japanese electronics maker Kyocera has released a wireless phone that has a large screen and uses the Palm operating system. (See both Alsop on Infotech and Personal Technology for differing views on the Kyocera phone.) But the Kyocera fuses two operating systems in its chip set: one that runs the organizer and another that runs the cell-phone functions. The Stinger has one system. Holden boasts, "I don't see Palm as a competitor in a year's time. My main competition going forward is Handspring and Nokia."

So why hasn't Palm, the market leader, responded with its own combo unit? Yankowski and others argue that their priority isn't rushing to market but providing simple, elegant solutions. "You expect that the phonemakers would be able to do [cell-phone/personal organizer] mating first. We have our own products in the hopper," Yankowski says. Still, he admits that Palm has been behind the curve. "The product-development pool was pretty empty when I inherited this business," he allows. "The company was focused on the IPO and getting the company spun off. 3Com obviously had its own issues, and I don't think they were heavily investing in this particular business."

For now, however, Yankowski must focus on doing the kinds of things that CEOs at the helm of troubled companies must do--cutting costs and trying to steer the company into new markets. In recent weeks he has trimmed Palm's work force by 15%, or 300 jobs, and halted plans to build a new multimillion-dollar corporate headquarters in San Jose. He also divided the company into new business units to help it win new customers.

Yankowski's greatest hopes are for the corporate market. Since the whole cult-of-Palm movement was largely driven by individuals who wanted to be more efficient, Yankowski is betting that corporations eager to pinch pennies might now see the Palm as an alternative to laptops and start buying it in mass quantities. "I just sold about 15,000 Palms to Sears for their retail sales force," he brags. Schools are another market that Palm will attempt to tap. And Palm engineers are working with Visa on technology that will let consumers use their Palms to make electronic payments at retail stores.

Palm will not be alone in pursuing these markets, so Yankowski's insistence that he is finding his job easier than it was a year ago has a wistful ring to it. "Adversity tends to focus people more on success," he says, with a hint of Zen-like reasoning. That may be true. But iconic status can only help for so long. If Palm can no longer create objects of devotion, people will look elsewhere. Then the real adversity will begin.