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| PALM > SEC Filings for PALM > Form 10-Q on 9-Jan-2008 | All Recent SEC Filings |
9-Jan-2008
Quarterly Report
The following discussion should be read in conjunction with the condensed consolidated financial statements and notes to those financial statements included in this Form 10-Q. Our 52-53 week fiscal year ends on the Friday nearest to May 31, with each quarter ending on the Friday generally nearest August 31, November 30 and February 28. For presentation purposes, the periods have been presented as ending on November 30 and May 31.
This quarterly report contains forward-looking statements within the meaning of the federal securities laws, including, without limitation, statements concerning Palm's expectations, beliefs and/or intentions regarding the following: unrecognized compensation cost under our stock plans; stock price volatility; option exercise behavior under Palm's stock plans; our objective of being the leader in mobile computing; our intent to lead on design, ease-of-use and functionality and to serve a broad range of customers; revenue and income growth; expansion of the smartphone market and our ability to capitalize on this expansion; future demand for our products; declines in the handheld market; our product mix and margins; rebates and price protection; revenue and credit concentration with our largest customers; the development and introduction of new products and services; acceptance of our wireless products; competitors and competition in the markets in which Palm operates; the sufficiency of Palm's cash, cash equivalents and credit facility to satisfy its anticipated cash requirements; the effects of changes in market interest rates; our interest income; investment activities, the value of investments and the use of Palm's financial instruments; Palm's ability and intent to hold its auction rate security investments until a recovery of the auction process or until maturity; dividends; the deductibility of goodwill for tax purposes; adjustments of goodwill; the effect of unrecognized tax benefits; realization of, and actions which Palm may implement to realize, the tax benefits associated with Palm's net operating loss carryforwards; Palm's defenses to, and the effects and outcomes of, legal proceedings and litigation
matters; provisions in Palm's charter documents, Delaware law and a Stockholders' Agreement and the potential effects of a stockholder rights plan and Palm's relationship with Elevation Partners; restructuring charges for the third fiscal quarter of 2008; Palm's debt obligations, the related interest expense for future periods and the effect of any non-compliance; and the potential impact of our critical accounting policies and changes in financial accounting standards or practices. Actual results and events could differ materially from those contemplated by these forward-looking statements due to various risks and uncertainties, including those discussed in the "Risk Factors" section and elsewhere in this quarterly report. Palm undertakes no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this report.
Overview and Executive Summary
Palm, Inc. is a leading provider of mobile computing solutions. Our leadership is the result of creating devices that make it easy for end users to manage their lives and communicate with others, to access and share their most important information and to avail themselves to the power of computing wherever they are. We design our devices to appeal to consumer, professional, business, education and government users around the world. We currently offer Treo and Centro smartphones and handheld computers as well as add-ons and accessories. We distribute these products through a network of wireless carriers, retail and business distributors worldwide and direct to end customers.
Palm was founded on two fundamental beliefs: the future of personal computing is mobile and the mobile computing solutions that we create should deliver a powerful computing experience in a simple and intuitive manner. Eleven years after we introduced our first product, these beliefs remain the driving tenets of our business.
Our objective is to be the leader in mobile computing. We intend to achieve this objective by providing our customers and end users with high quality innovative products, services and support that are easy to use. Management periodically reviews certain key business metrics in order to evaluate our strategy and operational efficiency, allocate resources and maximize the financial performance of our business. These key business metrics include the following:
Revenue-Management reviews many elements to understand our revenue stream. These elements include supply availability, unit shipments, average selling prices and channel inventory levels. Revenues are impacted by unit shipments and variations in average selling prices. Unit shipments are determined by supply availability, timing of carrier certification, end-user and channel demand, and channel inventory. We monitor average selling prices throughout the product life cycle, taking into account market demand and competition. To avoid empty shelves at retail store locations and to minimize product returns and obsolescence, we strive to maintain channel inventory levels within a desired range.
Margins-We review gross margin in conjunction with revenues to maximize operating performance. We strive to improve our gross margin through disciplined cost and product life-cycle management, supply/demand management and control of our warranty and technical support costs. To achieve desired operating margins, we also monitor our operating expenses closely to keep them in line with our projected revenue.
Cash flows-We strive to convert operating results to cash. To that end, we carefully manage our working capital requirements through balancing accounts receivable and inventory with accounts payable. We monitor our cash balances to maintain cash available to support our operating, investing and financing requirements.
We believe the mobile computing solutions market dynamics are generally favorable to us. The high-speed wireless networks which enable true "always-on" connectivity are fueling the growth of the market for smartphone devices. With our computing heritage, we are able to work closely with carriers to deploy advanced wireless data applications that take advantage of their wireless data networks.
The smartphone market is emerging and people are beginning to understand the personal and professional benefits of being able to access email or browse the web on a smartphone. We intend to lead on design, ease-of-use, and functionality, and serve a broad range of customers with products focused on their needs. We expect this market to expand and we are focusing our efforts in order to capitalize on this expansion.
Critical Accounting Policies
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported in Palm's condensed consolidated financial statements and accompanying notes. We base our estimates and judgments on historical experience and on various other assumptions that we believe are reasonable under the circumstances. However, these estimates and judgments are subject to change and the best estimates and judgments routinely require adjustment. The amounts of assets and liabilities reported in our balance sheets and the amounts of revenues and expenses
reported for each of our fiscal periods are affected by estimates and assumptions which are used for, but not limited to, the accounting for rebates, price protection, product returns, allowance for doubtful accounts, warranty and technical service costs, royalty obligations, goodwill and intangible asset valuations, restructurings, inventory, stock-based compensation and income taxes. Actual results could differ from these estimates. The following critical accounting policies are significantly affected by judgments, assumptions and estimates used in the preparation of our condensed consolidated financial statements.
Revenue is recognized when earned in accordance with applicable accounting standards and guidance, including Staff Accounting Bulletin, or SAB, No. 104, Revenue Recognition, and AICPA Statement of Position, or SOP, No. 97-2, Software Revenue Recognition, as amended. We recognize revenues from sales of mobile computing devices under the terms of the customer agreement upon transfer of title to the customer, net of estimated returns, provided that the sales price is fixed or determinable, collection is determined to be probable and no significant obligations remain. For our web sales distributors, we recognize revenue based on a sell-through method utilizing information provided by the distributor. Sales to resellers are subject to agreements allowing for limited rights of return and price protection. Accordingly, revenue is reduced for our estimates of liability related to these rights. The estimate for returns is recorded at the time the related sale is recognized and is adjusted periodically based upon historical rates of returns and other related factors. Actual returns may differ from our estimates. The reserves for rebates and price protection are recorded at the time these programs are offered in accordance with Emerging Issues Task Force, or EITF, Issue No. 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor's Products), and are estimated based on specific programs, expected usage and historical experience. Actual claims for rebates and price protection may vary over time and could differ from our estimates.
Revenue from software arrangements with end users of our devices is recognized upon delivery of the software, provided that collection is determined to be probable and no significant obligations remain. For arrangements with multiple elements, we allocate revenue to each element using the residual method. When all of the undelivered elements are software-related, this allocation is based on vendor specific objective evidence, or VSOE, of fair value of the undelivered items. VSOE is based on the price determined by management having the relevant authority when the element is not yet sold separately, but is expected to be sold in the marketplace within six months of the initial determination of the price by management. When the undelivered elements include non-software related items, this allocation is based on objective and reliable evidence of fair value, in accordance with EITF Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. We defer the portion of the fee equal to the fair value of the undelivered elements until they are delivered.
The allowance for doubtful accounts is based on our assessment of the collectibility of specific customer accounts and an assessment of international, political and economic risk as well as the aging of the accounts receivable. If there is a change in a major customer's creditworthiness or actual defaults differ from our historical experience, our actual results could differ from our estimates of recoverability.
We accrue for warranty costs based on historical rates of repair as a percentage of shipment levels and the expected repair cost per unit, service policies and our experience with products in production or distribution. If we experience claims or significant changes in costs of services, such as third-party vendor charges, materials or freight, which could be higher or lower than our historical experience, our cost of revenues could differ from our estimates.
We accrue for royalty obligations to certain technology and patent holders based on (1) unit shipments of our smartphone and handheld computer devices, (2) as a percentage of applicable revenue for the net sales of products using certain software technologies or (3) as a fully paid-up license fee, all as determined in accordance with the applicable license agreements. Where agreements are not finalized, accrued royalty obligations represent management's current best estimates using appropriate assumptions and projections based on negotiations with third party licensors. We have accrued royalty obligations of $34.9 million and $29.4 million as of November 30, 2007 and May 31, 2007, respectively, including estimated royalties of $27.9 million and $23.1 million, respectively, which are reported in other accrued liabilities. While the amounts ultimately agreed upon may be more or less than the current accrual, management does not believe that finalization of the agreements would have had a material impact on the amounts reported for our financial position as of November 30, 2007 or on the results reported for the three months then ended; however, the effect of finalization of these agreements in the future may be significant to the period in which recorded.
Long-lived assets such as property and equipment are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not ultimately be recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its ultimate disposition.
We evaluate the recoverability of goodwill annually during the fourth quarter of the fiscal year, or more frequently if impairment indicators arise, as required under Statement of Financial Accounting Standard, or SFAS, No. 142, Goodwill and Other Intangible Assets. Goodwill is reviewed for impairment by applying a fair-value-based test at the reporting unit level within our single reporting segment. A goodwill impairment loss would be recorded for any goodwill that is determined to be impaired. Under SFAS No. 144, Accounting for the Disposal of Long-Lived Assets, intangible assets are evaluated whenever
events or changes in circumstances indicate that the carrying value of the asset may be impaired. An impairment loss would be recognized for an intangible asset to the extent that the asset's carrying value exceeds its fair value, which is determined based upon the estimated undiscounted future cash flows expected to result from the use of the asset, including disposition. Cash flow estimates used in evaluating for impairment represent management's best estimates using appropriate assumptions and projections at the time.
Effective for calendar year 2003, in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which supersedes EITF Issue No. 94-3, Liability Recognition for Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring), we record liabilities for costs associated with exit or disposal activities when the liability is incurred. Prior to calendar year 2003, in accordance with EITF Issue No. 94-3, we accrued for restructuring costs when we made a commitment to a firm exit plan that specifically identified all significant actions to be taken. We record initial restructuring charges based on assumptions and related estimates that we deem appropriate for the economic environment at the time these estimates are made. We reassess restructuring accruals on a quarterly basis to reflect changes in the costs of the restructuring activities, and we record new restructuring accruals as liabilities are incurred.
Inventory purchases and purchase commitments are based upon forecasts of future demand. We value our inventory at the lower of standard cost (which approximates first-in, first-out cost) or market. If we believe that demand no longer allows us to sell our inventory above cost or at all, we write down that inventory to market or write-off excess inventory levels. If customer demand subsequently differs from our forecasts, requirements for inventory write-offs could differ from our estimates.
We account for stock-based compensation in accordance with, SFAS No. 123(R), Share-Based Payment, under the modified prospective method. Under the fair value recognition provisions of this statement, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the requisite service period, which is generally the vesting period.
We rely primarily on the Black-Scholes option valuation model to determine the fair value of stock options and employee stock purchase plan shares. The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex variables. These variables include our expected stock price volatility over the term of the awards, projected employee stock option exercise behaviors, expected risk-free interest rate and expected dividends.
We estimate the expected term of options granted based on historical time from vesting until exercise and the expected term of employee stock purchase plan shares using the average life of the purchase periods under each offering. We estimate the volatility of our common stock based upon the implied volatility derived from the historical market prices of our traded options with similar terms. Our decision to use this measure of volatility was based upon the availability of actively traded options on our common stock and our assessment that this measure of volatility is more representative of future stock price trends than the historical volatility in our common stock. We base the risk-free interest rate for option valuation on Constant Maturity Rates provided by the U.S. Treasury with remaining terms similar to the expected term of the options. We do not anticipate paying any cash dividends in the foreseeable future and therefore use an expected dividend yield of zero in the option valuation model. In addition, SFAS No. 123(R) requires forfeitures of share-based awards to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest.
In accordance with SFAS No. 123(R), we determined the fair value of modifications made to stock options in September and October 2007 using the Trinomial Lattice simulation model. We used the inputs and assumptions described above for volatility, risk-free interest rate and estimated dividends. We also incorporated an early exercise multiple of 1.95, the stock prices on the dates of modification (adjusted for the $9.00 distribution) and the strike prices of the affected awards (adjusted for the $9.00 distribution).
The Geometric Brownian Motion simulation model was utilized to determine the fair value of stock options, RSUs and restricted stock awards granted with market conditions, in order to incorporate more complex variables than closed-form models such as the Black-Scholes option valuation model. We used the inputs and assumptions described above for volatility, risk-free interest rate and estimated dividends. We also incorporated the specific terms of the awards to simulate multiple stock price paths over the various vesting periods to determine the average net present value across the simulation trials. The Geometric Brownian Motion simulation model is based on trials simulating the achievement of the market conditions and calculating the net present value of the fair value over all of the trials.
There are significant differences among valuation models, and there is a possibility that we will adopt different valuation models in the future. This may result in a lack of consistency between periods and materially affect the fair value estimate of share-based payments. It may also result in a lack of comparability with other companies that use different models, methods and assumptions.
Our deferred tax assets are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. A valuation allowance reduces deferred tax assets to estimated realizable value, based on forecasts of results and certain of our tax planning strategies. The carrying value of our net deferred tax assets assumes that it is more likely than not that we will be able to generate sufficient future taxable income in certain tax jurisdictions to realize the net carrying value. The valuation allowance is reviewed quarterly and is maintained until sufficient positive evidence exists to support the reversal of the valuation allowance based upon current and preceding years' results of operations and anticipated profit levels in future years. If these estimates and related assumptions change in the future, we may be required to adjust our valuation allowance against the deferred tax assets with a corresponding impact to the provision for income taxes.
On June 1, 2007, we adopted Financial Accounting Standards Board, or FASB, Financial Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109", or FIN, No. 48. FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. As a result of the implementation of FIN No. 48, we recognize the tax liability for uncertain income tax positions on the income tax return based on the two-step process prescribed in the interpretation. The first step is to determine whether it is more likely than not that each income tax position would be sustained upon audit. The second step is to estimate and measure the tax benefit as the amount that has a greater than 50% likelihood of being realized upon ultimate settlement with the tax authority. Estimating these amounts requires us to determine the probability of various possible outcomes. We evaluate these uncertain tax positions on a quarterly basis. This evaluation is based on the consideration of several factors, including changes in facts or circumstances, changes in applicable tax law, settlement of issues under audit, and new exposures. If we later determine that our exposure is lower or that the liability is not sufficient to cover our revised expectations, we adjust the liability and effect a related change in our tax provision during the period in which we make such determination.
Our key critical accounting policies are periodically reviewed with the Audit Committee of the Board of Directors.
Results of Operations
Revenues
Three Months Ended November 30, Increase/ Six Months Ended November 30, Increase/
2007 2006 (Decrease) 2007 2006 (Decrease)
We derive our revenues from sales of our smartphone and handheld computing devices, add-ons and accessories. Revenues for the three months ended November 30, 2007 decreased approximately 11% from the three months ended November 30, 2006. Smartphone revenue was $282.4 million for the three months ended November 30, 2007 and was relatively flat compared to $283.0 million for the three months ended November 30, 2006. Handheld revenue was $67.2 million for the three months ended November 30, 2007 and decreased 39% from $110.0 million for the three months ended November 30, 2006. During the three months ended November 30, 2007, net device units shipped were 1,149,000 units at an average selling price of $297. During the three months ended November 30, 2006, net device units shipped were 1,206,000 units at an average selling price of $315. Of the 11% decrease in revenues, approximately 6 percentage points resulted from the decrease in average selling prices and approximately 5 percentage points resulted from the decrease in unit shipments and accessories sales. The decline in average selling price is primarily the result of a shift in product mix during the quarter which was more heavily weighted towards lower priced smartphone products as well as a reduction in the selling prices of certain of our smartphone products. The decrease in unit shipments is primarily due to a decline in traditional handheld unit shipments as a result of the declining handheld market, partially offset by an increase in smartphone unit shipments.
International revenues were approximately 27% of worldwide revenues in the three months ended November 30, 2007 compared with approximately 34% in the three months ended November 30, 2006. Of the 11% decrease in worldwide revenues in the three months ended November 30, 2007 as compared to the three months ended November 30, 2006, approximately 10 percentage points resulted from a decrease in international revenues and 1 percentage point resulted from a decrease in United States revenues. Average selling prices for our devices decreased by 4% in the United States and by 10% internationally during the three months ended November 30, 2007 from the three months ended November 30, 2006. The decrease in average selling prices is primarily the result of reductions in the selling prices of our existing smartphone products and the
introduction of new smartphone products at lower price points. Net device units shipped increased approximately 4% in the United States and decreased 22% internationally from the year-ago period. The increase in net units sold in the United States is due to the introduction of new smartphone products, offset by a decline in traditional handheld unit sales. The decrease in net units sold internationally is primarily due to a decline in traditional handheld unit sales, coupled with a slight decrease in smartphone unit sales.
Revenues for the six months ended November 30, 2007 decreased approximately 5% from the six months ended November 30, 2006. Smartphone revenue was $584.6 million for the six months ended November 30, 2007 and increased 6% from $551.8 million for the six months ended November 30, 2006. Handheld revenue was $125.8 million for the six months ended November 30, 2007 and decreased 36% from $196.9 million for the six months ended November 30, 2006. During the six months ended November 30, 2007, net device units shipped were 2,157,000 units at an average selling price of $321. During the six months ended November 30, 2006, net device units shipped were 2,191,000 units at an average selling price of $330. Of the 5% decrease in revenues, approximately 3 percentage points resulted from the decrease in average selling prices and approximately 2 percentage points resulted from the decrease in unit shipments and accessories sales. The decline in average selling price is primarily the result of a shift in product mix during the period which was more heavily weighted towards lower priced smartphone products, as well as a reduction of the selling prices of certain of our other smartphone products. The decrease in unit shipments is primarily due to a decline in traditional handheld unit shipments as a result of the declining handheld market, partially offset by an increase in smartphone unit shipments.
International revenues were approximately 24% of worldwide revenues in the six months ended November 30, 2007 compared with approximately 26% in the six months ended November 30, 2006. Of the 5% decrease in worldwide revenues for the six months ended November 30, 2007 as compared to the six months ended November 30, 2006, approximately 3 percentage points resulted from a decrease in . . .
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