10-K 1 d10k.htm FORM 10-K FOR THE FISCAL YEAR ENDED MAY 30, 2008 Form 10-K for the fiscal year ended May 30, 2008
Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

x   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE

ACT OF 1934

 

      

For the fiscal year ended May 30, 2008

or

 

¨   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934

For the transition period from                    to                   

Commission File No. 000-29597

Palm, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware   94-3150688

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

950 West Maude

Sunnyvale, California 94085

(Address of principal executive offices and zip code)

Registrant’s telephone number, including area code: (408) 617-7000

Securities Registered Pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on which registered

Common Stock, par value $0.001 per share and related Preferred Stock Purchase Rights   The NASDAQ Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  x  No  ¨

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes  ¨  No  x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  x

   Accelerated filer  ¨

Non-accelerated filer  ¨   (Do not check if a smaller reporting company)

   Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b of the Exchange Act)  Yes  ¨  No  x

The aggregate market value of the registrant’s Common Stock held by non-affiliates, based upon the closing price of the Common Stock on November 30, 2007, as reported by the Nasdaq Global Select Market, was approximately $407,021,000. Shares of Common Stock held by each executive officer and director and by each person who owns 5% or more of the outstanding Common Stock, based on filings with the Securities and Exchange Commission, have been excluded since such persons may be deemed affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of June 27, 2008, 108,444,768 shares of the registrant’s Common Stock were outstanding.

 

 

DOCUMENTS INCORPORATED BY REFERENCE

The registrant’s proxy statement relating to the 2008 Annual Meeting of Stockholders, to be filed within 120 days of the end of the fiscal year ended May 30, 2008, is incorporated by reference in Part III of this Form 10-K to the extent stated herein.

 

 

 


Table of Contents

 

Palm, Inc.

Form 10-K

For the Fiscal Year Ended May 31, 2008*

Table of Contents

 

          Page
     Part I     

Item 1.

   Business    3

Item 1A.

   Risk Factors    13

Item 1B.

   Unresolved Staff Comments    33

Item 2.

   Properties    33

Item 3.

   Legal Proceedings    33

Item 4.

   Submission of Matters to a Vote of Security Holders    33
   Part II   

Item 5.

   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    34

Item 6.

   Selected Financial Data    35

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    36

Item 7A.

   Quantitative and Qualitative Disclosures About Market Risk    59

Item 8.

   Financial Statements and Supplementary Data    61

Item 9.

   Changes in and Disagreements With Accountants on Accounting and Financial Disclosure    103

Item 9A.

   Controls and Procedures    103

Item 9B.

   Other Information    105
   Part III   

Item 10.

   Directors, Executive Officers and Corporate Governance    105

Item 11.

   Executive Compensation    105

Item 12.

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    105

Item 13.

   Certain Relationships and Related Transactions, and Director Independence    105

Item 14.

   Principal Accounting Fees and Services    105
   Part IV   

Item 15.

   Exhibits, Financial Statement Schedule    106
   Signatures    111
   Schedule II—Valuation and Qualifying Accounts    112

 

*   Our fiscal year ends on the Friday nearest May 31. For presentation purposes, the periods have been presented as ending on May 31.

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS:

We may make statements in this Annual Report on Form 10-K, such as statements regarding our plans, objectives, expectations and intentions that are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements generally are identified by the words “believes,” “expects,” “anticipates,” “estimates,” “intends,” “strategy,” “plan,” “may,” “will,” “would” and similar expressions and include, without limitation, statements regarding our intentions, expectations and beliefs regarding: mobile products and the mobile product market; our leadership position in mobile products; our market share; our ability to grow our business; our revenue, gross margins, operating income, operating results and profitability; our corporate strategy; developing market-defining products; growth in the smartphone market; capitalizing on industry trends and dynamics; economic trends and market conditions; our platform strategy; increasing the adoption of smartphones; the benefits of advertising; the domestic and international market opportunity available to us; international, political and economic risk; the development and introduction of new products and services; acceptance of our smartphone products; market demand for our products; our ability to differentiate our products, develop products to serve a broad range of customers, attract new customers and drive the upgrade cycle by consumers; our ability to lead on design, ease-of-use and functionality; pricing and average selling prices for our products; the development and timing of our new operating system and related software and the introduction of products based on this new platform; competition and our competitive advantages; our ability to build our brand and consumers’ awareness of our products; the resources that we and our competitors devote to development, promotion and sale of products; our expectations regarding our product lines; our product mix; our ability to broaden and expand our wireless carrier relationships; revenue and credit concentration with our largest customers; our ability to cause application providers to provide applications for our products; royalty obligations; inventory, channel inventory levels and inventory valuation; repair costs; rights of return; rebates and price protection; product warranty accrual and liability; our forecasted product and manufacturing requirements; seasonality in sales of our products; the adequacy of our properties, facilities and operating leases and our ability to secure additional space; our tax strategy; realization and recoverability of our net deferred tax assets; the need to increase our deferred tax asset valuation allowance; utilization of our net operating loss and tax credit carryforwards; our belief that our cash, cash equivalents and short-term investments will be sufficient to satisfy our anticipated cash requirements; impairment charges in connection with our investments in auction rate securities; the liquidity of, holding periods for and our ability and intent to hold our auction rate securities; the completion of restructuring actions; compensation and other expense reductions; dividends; interest rates; the timing and amount of our cash generation and cash flows; declines in the handheld market and in our handheld business; our use of options, restricted stock and restricted stock units; unrecognized compensation cost under our stock plans; stock price volatility; option exercise behavior under our stock plans; vesting, terms and forfeiture of our equity awards; our stock-based compensation valuation models; our defenses to, and the effects and outcomes of, legal proceedings and litigation matters; provisions in our charter documents, Delaware law and a Stockholders’ Agreement and the potential effects of a stockholder rights plan; our relationship with Elevation Partners, L.P.; our 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. These statements are subject to risks and uncertainties that could cause actual results and events to differ materially. A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section entitled “Risk Factors” on page 13 herein. We undertake no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this Annual Report on Form 10-K.

Palm, Treo, Centro, Foleo, Tungsten and Palm OS are among the trademarks or registered trademarks owned by or licensed to Palm, Inc. All other brand and product names are or may be trademarks of, and are used to identify products or services of, their respective owners.

 

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Part I

Item 1.    Business

Business Summary

Palm, Inc. is a leading provider of mobile products that enhance the lifestyles of individual users and business customers worldwide. Our leadership results from creating thoughtfully integrated technologies that better enable people to stay connected with their family, friends and colleagues, access and share the information that matters to them most and manage their daily lives on the go. Palm offers Treo™ and Centro™ smartphones, handheld computers and accessories through a network of wireless carriers, as well as retail and business outlets worldwide.

Corporate Background

We were incorporated in 1992 as Palm Computing, Inc. In 1995, we were acquired by U.S. Robotics Corporation. In 1996, we sold our first handheld computer, quickly establishing a significant position in the handheld computer industry. In 1997, 3Com Corporation, or 3Com, acquired U.S. Robotics. In 1999, 3Com announced its intent to separate our business from 3Com’s business to form an independent, publicly-traded company. In preparation for that spin-off, Palm Computing, Inc. changed its name to Palm, Inc., or Palm, and was reincorporated in Delaware in December 1999. In March 2000, Palm sold shares in an initial public offering and concurrent private placements. In July 2000, 3Com distributed its remaining shares of Palm common stock to 3Com stockholders.

In December 2001, Palm formed PalmSource, Inc., or PalmSource, a stand-alone subsidiary for its operating system, or OS, business. On October 28, 2003, Palm distributed all of the shares of PalmSource common stock held by Palm to Palm stockholders. On October 29, 2003, we acquired Handspring, Inc., or Handspring, and changed our name to palmOne, Inc., or palmOne.

In connection with our spin-off of PalmSource, Palm Trademark Holding Company, LLC, or PTHC, was formed to hold trade names, trademarks, service marks and domain names containing the word or letter string “palm”. In May 2005, we acquired PalmSource’s interest in PTHC, including the Palm trademark and brand. In July 2005, we changed our name back to Palm, Inc., or Palm.

In October 2007, we sold shares of Series B Redeemable Convertible Preferred Stock, or Series B Preferred Stock, to the private-equity firm Elevation Partners, L.P. On an as-converted basis, these shares represent approximately 26% of our voting shares as of May 31, 2008. As a result of this transaction, Elevation Partners, L.P. has the right to elect two members to our Board of Directors.

Corporate Strategy

Our objective is to be the leader in mobile lifestyle products for individual users and business customers. To achieve this, we focus on the following strategies:

 

  ·  

Differentiate our products through innovative software, inspiring industrial design and the seamless integration of hardware, system software, applications and services to deliver a delightful mobile user experience. We have a track record of innovation and creating new product categories. We revolutionized the handheld computing business in 1996 with the launch of the Pilot—the “connected organizer”—that allowed users to synchronize their calendar and contact list with a personal computer. We set the standard in smartphones with our Treo products and have continued to attract new users to the category with our successful Centro products. Customer requirements and user experience drive our product design and development. Our Treo and Centro products combine a powerful phone experience with easy messaging, personal and work email, mobile web browsing, entertainment features and personal information management. We are recognized by our industry and our customers for consistently delivering the easiest-to-use products in our category.

 

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  ·  

Deliver a range of product choices around open platforms. Palm believes in the power of open platforms and the ecosystems that develop around those platforms of software and accessory developers that increase the breadth of solutions for a wide range of customers. Palm created the first successful open mobile development platform and continues today to offer individual users its trademark ease of use and integrated personal information management through the Palm systems software, currently based on the Palm Operating System by Access, or Palm OS. In addition, we partner with Microsoft to deliver a robust Windows Mobile user experience targeted to business customers who want to tie into their existing Microsoft-based systems for use at work and at home.

 

  ·  

Focus on our core competencies by using a leveraged model to develop, manufacture, distribute and support our products. Palm leverages relationships with world class original design manufacturers, or ODMs, technology and service suppliers and wireless carriers to help design, manufacture, distribute and support our products worldwide. As a result, we are able to focus on our core competency as a technology and software innovator.

 

  ·  

Build a brand synonymous with a mobile lifestyle. The Palm brand has widespread recognition and identification with mobile products. We build end-user awareness and preference for our products and our brand by focusing on the user experience and delivering products that generate strong customer loyalty. We also strive to enhance our brand through marketing, public relations, customer service and support, as well as community involvement. We believe that developing a strong Palm brand is key to product differentiation and market leadership.

Products and Services

We sell mobile products in two product lines: smartphones and handheld computers. Our product lines provide a wide range of business productivity tools and personal and entertainment applications designed for mobile professionals and business customers as well as entry-level consumers.

Our products currently run on the Palm systems platform or Windows Mobile OS platform. We are currently developing a new OS and related next-generation systems software. We have announced that we expect this new OS and software to be completed in time to ship products based on this platform in the first half of calendar year 2009.

Our products are differentiated in terms of price, design, functionality and software applications that are delivered with the device. All of our products incorporate our hallmark of powerful simplicity, including instant-on one-touch access to the most frequently used applications and non-volatile flash memory that protects stored data even if the charge and power run out. Other features found in some of our products include:

 

  ·  

wireless communication capabilities, such as Bluetooth and wireless fidelity, or Wi-Fi;

 

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support for IS95/CDMA2000/EvDO or GSM/GPRS/EDGE/UMTS/HSDPA network protocols, which enable messaging, email, web browsing, wireless synchronization and telephone communications;

 

  ·  

multimedia features, allowing users to capture and view photos and video clips, listen to MP3 files and watch movies via audio and video streaming;

 

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a slot for stamp-sized expansion cards for storage, content and input/output devices; and

 

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productivity software, such as DataViz’s Documents to Go which allows users to create, view and edit Microsoft Office Word and Microsoft Office Excel files and view Microsoft Office PowerPoint Mobile presentations.

 

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Treo and Centro Smartphones

Our Treo and Centro smartphones combine a full-featured mobile phone, wireless data applications, such as email, messaging and web browsing, multimedia features and productivity software in a small, compact, easy-to-use device that simplifies both business and personal life by integrating these applications into a single device. We design Treo and Centro smartphones for individuals who would otherwise carry multiple devices such as a cell phone and laptop. We customize our Treo and Centro smartphones for wireless carrier networks in markets around the world, such as AT&T, Inc., Sprint Corporation and Verizon Wireless in the United States and America Movil, Telstra and Vodafone internationally. We also offer non-customized versions of some of our Treo and Centro smartphone products through other wireless carriers and distributors worldwide. We currently offer the Centro and Treo 755p smartphones on the Palm OS platform and the Treo 700wx, 750, 500 and 800w smartphones powered by Windows Mobile. Each of these smartphones includes data synchronization technology, enabling the device to synchronize with desktop applications such as Microsoft Office Outlook and an infrared port for exchanging information between devices. Organizer software is also standard in our smartphone products, including an address book, date book, clock, to-do list, memo pad and calculator. In addition, most of our smartphones feature wireless modem capabilities, access to email, ability to respond to phone calls using text messaging, a QWERTY/AZERTY keyboard, a touch-screen, built-in viewers and editors allowing users to view and edit Word and Excel files and/or the ability to listen to music and view videos.

Palm OS Platform

The Centro smartphone was introduced in September 2007 and is the fastest selling smartphone in Palm history. The Centro was launched at a lower price point to reach a new end-user demographic, and is the smallest and lightest Palm phone to date. It runs on a version of the Palm OS that takes advantage of EvDO data speeds on broadband wireless networks. The Centro provides a fun, new compact design. The Centro smartphone is available through AT&T, Sprint and Verizon in the United States and a variety of wireless carriers in other countries.

The Treo 755p dual-band smartphone was introduced in December 2007. It runs on a version of the Palm OS that takes advantage of EvDO data speeds on broadband wireless networks. The Treo 755p has high-speed browsing capabilities. The Treo 755p smartphone is available through Sprint and Verizon in the United States and a variety of wireless carriers in other countries.

Windows Mobile OS Platform

The Treo 700wx digital dual-band smartphone was introduced in September 2006. It runs on Windows Mobile 5.0 which we have uniquely customized. It is designed to take advantage of CDMA2000 EvDO data speeds on broadband wireless networks. The Windows Mobile powered Treo 700wx is Direct Push email capable. The Treo 700wx smartphone is available through Sprint and Verizon in the United States and a variety of wireless carriers in other countries.

The Treo 750 quad-band GSM and tri-band UMTS smartphone was introduced in September 2006. It runs on Windows Mobile 6.0. The Treo 750 is Palm’s first UMTS product and is compatible with 3G UMTS/HSDPA networks. The Treo 750 allows mobile access to multiple business and personal email accounts, video and high-speed browsing and contains enhanced technology to support Bluetooth enabled stereo headsets. The Treo 750 smartphone is available through Vodafone in Europe, AT&T in the United States and a variety of wireless carriers in other countries.

The Treo 500 tri-band GSM and UMTS smartphone was introduced in September 2007. It runs on Windows Mobile 5 Standard. The Treo 500 combines multiple forms of communication and multimedia capabilities with high speed 3G UMTS/HSDPA mobile internet access in a compact package. The Treo 500 smartphone is available outside the United States.

 

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The Treo 800w digital dual-band smartphone was introduced in July 2008. It runs on Windows Mobile 6.1. In addition to a touchscreen and Palm’s hardware and software enhancements, this is the first Palm smartphone that has Wi-Fi, runs on EvDO Rev A high speed networks and, depending on the wireless carrier, has either built-in or downloadable GPS. The Treo 800w is available through Sprint in the United States.

Handheld Computers

Palm and Tungsten handheld computers include data synchronization technology (HotSync), enabling the devices to synchronize with desktop applications such as Outlook, and an infrared port for exchanging information between devices. Organizer software is also standard in our handheld computers, including an address book, date book, clock, to-do list, memo pad and calculator. The Palm and Tungsten handheld computers include advanced technologies that provide efficient personal information management and media experiences for entry-level consumers, mobile professionals and serious business users alike. We currently offer the Palm Z22, Tungsten E2 and Palm TX handheld computers.

The Palm Z22’s mix of price, functionality and performance allows us to expand our available market to new users, as indicated by our user registration data. We believe that by making an entry-level product such as the Z22 available, we are driving the early adoption of mobile products by consumers who would not otherwise own such a device. This increases the potential for future upgrade purchases as end users become accustomed to mobile product technology and demand additional functionality.

The Tungsten E2 is intended for cost-conscious professionals who require robust power and performance. The Tungsten E2 provides non-volatile flash memory and allows users to create, edit and view Word and Excel files with DataViz Documents to Go as well as listen to MP3 files and watch video clips.

The Palm TX is designed for professionals and business users who require premium computing power and performance. The Palm TX offers wireless capability using Bluetooth and Wi-Fi and the ability to store, create, edit and view Word and Excel files with DataViz Documents to Go.

Add-ons and Accessories

We offer add-ons and accessories to enhance the end user’s experience, including portable keyboards, memory expansion cards for storage and content, modems, headsets and carrying cases. In addition, we provide the ability to purchase and download software applications through a link on our Palm.com website.

Competition

Competition in the mobile product market is intense and characterized by rapid change and complex technology. The principal competitive factors affecting the market for our mobile products are access to sales and distribution channels, price, product quality and time to market. These factors are influenced by styling, usability, functionality, features, OS, brand, marketing, availability of third-party software applications and customer and developer support. Our devices compete with a variety of mobile products, including pen-and keyboard-based devices, mobile phones, converged voice/data devices and mobile and desktop computers.

Our principal competitors include: mobile handset and smartphone manufacturers such as Apple, Asustek, High Tech Computer, or HTC, LG, Motorola, Nokia, Pantech, Research in Motion, or RIM, Samsung and Sony-Ericsson; and computing device companies such as Acer, Hewlett-Packard and Mio Technology. In addition, our products compete for a share of disposable income and business spending on consumer electronic, telecommunications and computing products such as MP3 players, iPods, media/photo viewers, digital cameras, personal media players, digital storage devices, handheld gaming devices, GPS devices and other such devices.

 

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Some of our competitors, such as Asustek and HTC, produce smartphones as wireless-carrier-branded devices in addition to their own branded devices. As technology advances, we also expect to compete with mobile phones without branded operating systems that synchronize with personal computers, as well as ultra mobile personal computers and laptop computers with wide area network or data cards and voice over IP, or VoIP, and Wi-Fi phones with VoIP.

We believe we compete favorably with respect to some or all of the competitive factors affecting the mobile product market, which is reflected by our installed base of mobile product users, market share and brand recognition.

Sales and Marketing

We sell our products to wireless carriers, distributors, retailers and resellers through our sales force. Also, we sell to end users through our web site at www.palm.com.

For our smartphone products, wireless carriers collectively represent our largest sales channel, particularly in the United States. We also sell smartphones through distribution partners, particularly in Asia Pacific, Canada, Europe and Latin America where the distributors may customize our products for each country or region. These wireless carriers and distributors have a strong influence over the visibility and promotion of our products. In the case of smartphones, our end users often choose their phones based on what their chosen wireless carrier offers, and rely on the wireless carrier for wireless access, complementary applications, accessories and services the wireless carrier provides. We have worked to develop strong relationships with a variety of wireless carriers around the world. Some of our wireless carrier relationships include AT&T, Sprint and Verizon in the United States, Vodafone in Europe, America Movil and Movistar in Latin America and Telstra in the Asia Pacific region. We work with wireless carriers in different ways, depending on each wireless carrier’s unique situation and requirements. Some of these relationships include product customization for the wireless carrier’s network, systems integration or joint marketing and sales. Other wireless carriers typically purchase non-customized smartphones either from us directly or from a Palm-approved distributor. In addition, in conjunction with some of our wireless carrier partners we offer end-user and mail-in rebates for our smartphones to improve our competitive position in the marketplace. We have dedicated wireless carrier account teams for our largest wireless carrier customers by region. These teams are responsible for selling our products to those wireless carriers and ensuring certification on their networks. These teams also provide sales, marketing, training and technical support to help those wireless carriers sell Treo and Centro smartphones through their retail and business channels.

We have sales teams dedicated to selling our smartphone products to business customers. These dedicated teams educate and train wireless carrier and distributor business-to-business representatives on the advantages of the Treo and Centro smartphones and also work with business customers directly.

For our handheld computer products in the United States, retailers represent our largest sales channel and include national and regional office supply stores and consumer electronics retailers. Distributors represent our second largest United States sales channel for handheld computers and generally sell to both traditional and Internet retailers and resellers, including enterprise and education resellers. Internationally, we sell our products primarily through distributors who sell to retailers and resellers.

We use our Palm.com webstore as a direct sales channel to sell our products and third-party products, focusing particularly on our customer base. We also offer a wide array of software titles on the Software Connection website which can be accessed from the Palm.com webstore.

We build awareness of our products and brands through select Palm marketing and cooperative marketing with wireless carriers and other distributors. To do so, we employ methods such as advertising, product placements, public relations efforts, in-store promotions and merchandising and retail and online advertising. We

 

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engage in direct marketing through mailings, email and promotions to users in our customer database. We also receive feedback from our end users and our channel customers through market research. We use this feedback to refine our product development efforts and to develop strategies for marketing our products.

Customers

In fiscal years 2008, 2007 and 2006, our largest customers represented the following percentages of consolidated revenues, respectively:

 

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Sprint Corporation represented 41%, 24% and 14%;

 

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Verizon Wireless represented 13%, 18% and 30%; and

 

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AT&T, Inc. represented 11%, 14% and 11%.

AT&T Inc., Sprint Corporation and Verizon Wireless are wireless carriers in the United States.

Customer Service and Support

For our smartphone products in the United States, our wireless carrier partners generally handle first line support. For our smartphone products outside the United States, handheld computer products and escalation support, we generally provide customer support through outsourced service providers as well as our internal customer service personnel. In addition, we offer a program in which we assist our customers through the set-up process of certain of our smartphone products. We also offer premium support services for an additional fee to our enterprise customers.

Individual customers have access to a number of self-service tools for general inquiries, technical information and troubleshooting techniques. These include the support pages on the Palm website and the help forum and Internet-based knowledge library that can be accessed through the Palm website. Also, for the first 90 days after purchase, individual customers can obtain agent-assisted help through web chat and telephone support.

We warrant that our products will be free of defect for 90 to 365 days after the date of purchase, depending on the product. In Europe we are required in some countries to provide a two-year warranty for certain defects. We contract with third parties to handle warranty repair.

Research and Development

Our products are initially conceived, designed, developed and implemented through the collaboration of our internal engineering, marketing and supply chain organizations. We focus our product design efforts on both improving our existing products and developing new products. We intend to continue to employ a customer-focused design approach to provide innovative products that respond to and anticipate customer needs for functionality, mobility, simplicity, style and ease of use.

We either create internally or license from third parties the technologies required to support product development. Our internal staff includes engineers of many disciplines, including software engineers, electrical engineers, mechanical engineers, radio specialists, quality engineers and user interface design specialists. Once a product concept is initiated and approved, we create a multi-disciplinary team to complete the design of the product and transition it into manufacturing. We often utilize original design manufacturers, or ODMs, to design, develop and manufacture our products after we have internally completed product definition. Our hardware is developed and manufactured by a limited number of ODMs.

Although hardware is the most visible aspect of our products, we provide most of the value and differentiation to our products through software development and integration of the software with the hardware. This software development is aimed at enhancing and extending the platform software and at integrating and innovating application software functionality.

 

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All of our devices must receive approval from relevant governmental agencies, such as the Federal Communications Commission in the United States. Our Treo and Centro smartphones are also typically required to pass individual wireless carrier certification requirements before they may be operated on a wireless carrier’s network. In addition, our devices may require certification from various standard-setting bodies around the world. We have established an internal certification team and wireless carrier certification processes, including early testing, to facilitate our ability to meet these certification and standards requirements.

Most of our internal research and development is based at our headquarters in Sunnyvale, California. We also operate research and development facilities in San Diego, California and Dublin, Ireland.

Our research and development expenses totaled $202.8 million, $191.0 million and $136.2 million in fiscal years 2008, 2007 and 2006, respectively.

Manufacturing and Supply Chain

We outsource the manufacturing of our products to third-party manufacturers. This outsourcing extends from prototyping to volume manufacturing and includes activities such as material procurement, final assembly, test, quality control and shipment to distribution centers. Currently the majority of our products are assembled in China and Taiwan by a limited number of ODMs. We also have entered into an agreement with a third party to manufacture our products in Brazil for distribution in Brazil. Distribution centers are operated on an outsourced basis in Illinois in the United States and in Hong Kong and Ireland internationally. In some cases, our ODMs ship products directly to our wireless carrier customers’ distribution centers.

The components that make up our products are purchased from various vendors, including key suppliers such as Broadcom, LG, Marvel, Qualcomm, Samsung, Sharp and Sony. Some of our components, including radio components, power supply integrated circuits, cameras and certain discrete components, are currently supplied by sole source suppliers.

We are subject to various environmental and other regulations governing product safety, materials usage, packaging and other environmental impacts in the various countries where our products are sold. Our products are subject to laws and regulations restricting the use of certain materials and which may require us to assume responsibility for collecting, treating, recycling and disposing of our products when they have reached the end of their useful lives.

Backlog

Most wireless carriers purchase our smartphones through negotiated contracts, each of which is unique. Generally, the terms of sale include purchase commitments if a wireless carrier requires smartphones that are customized to its network. Wireless carrier purchase terms vary; however, cancellations are generally limited and may carry penalties. Typically, smaller wireless carriers purchase non-customized product through distributors.

Orders for our handheld computer products are generally placed on an as-needed basis, and products are shipped as soon as possible after receipt of an order, usually within one to four weeks. Handheld computer product orders may be cancelled or rescheduled by the customer without penalty. Consequently, we rarely carry backlog on our handheld computer products.

The backlog of firm orders on our smartphone products was $237.5 million as of May 31, 2008 compared to $184.7 million as of May 31, 2007 and $120.6 million as of May 31, 2006.

 

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Seasonality

We have not seen significant seasonal variations in customer demand for our Treo smartphones. By contrast, since the introduction of the consumer-oriented Centro smartphone in September 2007, we have seen evidence of seasonality with its sales strengthening in the second and fourth quarters of our fiscal year as wireless carriers stock up for the December holiday selling season and the Mother’s Day, Father’s Day and graduation selling seasons, respectively.

Our handheld computer lines have historically been affected by seasonality, with associated revenues generally sequentially higher in the second quarter of our fiscal year, as distributors and retailers purchase product in anticipation of the December holiday selling season. We also have historically experienced smaller positive effects on revenue in the first and fourth quarters of our fiscal year, as distributors and retailers purchase product in anticipation of the back-to-school and the Father’s Day and graduation selling seasons, respectively.

Intellectual Property

We rely on a combination of know-how, patents, trademarks and copyrights, as well as trade secret laws, confidentiality procedures and contractual restrictions to protect our intellectual property rights. We invest strategically in our intellectual property portfolio in order to support our continued innovation, to be able to deliver compelling products to our customers and to build the overall value of our company and brand.

We continue to work on increasing and protecting our rights in our patent portfolio. We grow our patent portfolio through internal development, as well as acquisitions from time to time. While our patents are important to our business, our business is not materially dependent on any one patent. We file domestic and foreign patent applications to support our technology position and new product development, and we have over 1,200 patent assets (patents and patent applications) worldwide. Patents typically expire 20 years from the filing date subject to adjustments by certain countries’ patent offices. Patents relating to the mobile products industry are being issued and new patent applications are being filed with increasing regularity. As a result, there are many patents and related rights that may affect our products. In addition, new and existing companies are increasingly engaging in the business of acquiring or developing patents to assert offensively against companies such as Palm. This trend increases the likelihood that we will be subject to allegations and claims of infringement. We have been named in several patent infringement lawsuits to date, some of which are described in greater detail in Item 3, Legal Proceedings. In addition, as is common in our industry, we obtain indemnification from and agree to indemnify certain third parties for alleged patent infringement.

We own, directly or indirectly, a number of trademarks, including the PALM mark and certain PALM-formative marks as well as the TREO and CENTRO marks. We have registrations or pending applications for registration for such marks in the United States and other jurisdictions. In connection with our acquisition of PalmSource’s interest in PTHC, we provided a four-year transitional license to PalmSource for certain marks containing the word or letter string “palm”, including PALM OS. This license expires in May 2009. We are working to increase and protect our rights in our trademark portfolio, which is important to our value, reputation and branding.

We also license technologies from third parties for integration into our products. We believe that the licensing of complementary technologies from third parties with specific expertise is an effective means of expanding the features and functionality of our products, allowing us to focus on our core competencies. Our most significant licenses are the Palm OS from ACCESS Systems Americas, Inc. (formerly PalmSource, Inc.) and Windows Mobile from Microsoft. We also license conduit software that allows for synchronization with Outlook, encryption technology, radio technology and a variety of other software technologies.

Consistent with our efforts to maintain the confidentiality and ownership of our trade secrets and other confidential information and to protect and build our intellectual property rights, we generally require our employees, consultants and customers, manufacturers, suppliers and other persons with whom we do business or

 

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may potentially do business to execute confidentiality agreements as well as invention assignment agreements, if applicable, upon commencement of a relationship with us. Such agreements typically extend for a period of time beyond termination of the relationship.

Employees

As of May 31, 2008, we had a total of 1,050 employees, of whom 104 were in supply chain, 524 were in engineering, 260 were in sales and marketing and 162 were in general and administrative roles. None of our employees are subject to a collective bargaining agreement. We consider our relationship with our employees to be good.

Fiscal Year End

Our fiscal year ends on the Friday nearest May 31. For presentation purposes, the periods have been presented as ending on May 31. Fiscal years 2008, 2007 and 2006 each contained 52 weeks.

Product Information

Palm sells products in two product lines: smartphones and handheld computers through May 31, 2008. Revenues by product line are as follows (in thousands):

 

     Years Ended May 31,
     2008    2007    2006

Revenues:

        

Smartphones

   $ 1,125,581    $ 1,250,040    $ 1,088,312

Handheld computers

     193,110      310,467      490,197
                    
   $ 1,318,691    $ 1,560,507    $ 1,578,509
                    

Financial Information about Segments

Palm operates in one reportable segment which develops, designs and markets mobile products as well as related add-ons and accessories (in thousands):

 

     Years Ended May 31,
     2008     2007    2006

Revenues

   $ 1,318,691     $ 1,560,507    $ 1,578,509

Net income (loss)

     (105,419 )     56,383      336,170
     May 31,
     2008     2007    2006

Total assets

   $ 1,180,262     $ 1,548,002    $ 1,487,522

 

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Financial Information about Geographic Areas

Our headquarters and most of our operations are located in the United States. We conduct our sales, marketing and customer service activities throughout the world. Geographic revenue information is based on the location of the customer. For fiscal years 2008, 2007 and 2006, no single country outside the United States accounted for 10% or more of total revenues (in thousands):

 

     Years Ended May 31,
     2008    2007    2006

Revenues:

        

United States

   $ 1,043,161    $ 1,174,265    $ 1,203,918

Other

     275,530      386,242      374,591
                    
   $ 1,318,691    $ 1,560,507    $ 1,578,509
                    
     May 31,
     2008    2007    2006

Land held for sale, property and equipment, net (in thousands):

        

United States

   $ 38,638    $ 95,370    $ 81,295

Other

     998      1,264      1,695
                    
   $ 39,636    $ 96,634    $ 82,990
                    

Available Information

We make available free of charge through our website, www.palm.com, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements and all amendments to those reports as soon as reasonably practicable after such material is electronically filed or furnished with the Securities and Exchange Commission, or SEC. These reports may also be obtained without charge by contacting Investor Relations, Palm, Inc., 950 West Maude Avenue, Sunnyvale, California 94085, phone: 1-408-617-7626, email: investor.relations@palm.com. Our Internet website and the information contained or incorporated therein are not intended to be incorporated into this Annual Report on Form 10-K. In addition, the public may read and copy any materials we file or furnish with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549 or may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Moreover, the SEC maintains an Internet site that contains reports, proxy and information statements, and other information that we file or furnish electronically with them at http://www.sec.gov.

 

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Item 1A.    Risk Factors

You should carefully consider the risks described below and the other information in this Form 10-K. The business, results of operations or financial condition of Palm could be seriously harmed and the trading price of Palm common stock may decline due to any of these risks.

Risks Related to Our Business

Our operating results are subject to fluctuations, and if we fail to meet the expectations of securities analysts or investors, our stock price may decrease significantly.

Our operating results are difficult to forecast. Our future operating results may fluctuate significantly and may not meet our expectations or those of securities analysts or investors. If this occurs, the price of our stock will likely decline. Many factors may cause fluctuations in our operating results including, but not limited to, the following:

 

  ·  

timely introduction and market acceptance of new products and services;

 

  ·  

loss or failure of wireless carriers or other key sales channel partners;

 

  ·  

quality issues with our products;

 

  ·  

competition from other smartphones or other devices;

 

  ·  

changes in consumer, business and wireless carrier preferences for our products and services;

 

  ·  

failure to achieve product cost and operating expense targets;

 

  ·  

changes in and competition for consumer and business spending levels;

 

  ·  

failure by our third-party manufacturers or suppliers to meet our quantity and quality requirements for products or product components on time;

 

  ·  

failure to add or replace third-party manufacturers or suppliers in a timely manner;

 

  ·  

seasonality of demand for some of our products;

 

  ·  

changes in terms, pricing or promotional programs;

 

  ·  

variations in product costs or the mix of products sold;

 

  ·  

excess inventory or insufficient inventory to meet demand;

 

  ·  

growth, decline, volatility and changing market conditions in the markets we serve;

 

  ·  

litigation brought against us; and

 

  ·  

changes in general economic conditions and specific market conditions.

Any of the foregoing factors could have an adverse effect on our business, results of operations and financial condition.

If we fail to develop and introduce new products and services successfully and in a cost-effective and timely manner, we will not be able to compete effectively and our ability to generate revenues will suffer.

We operate in a highly competitive, rapidly evolving environment, and our success depends on our ability to develop and introduce new products and services that our customers and end users choose to buy. If we are unsuccessful at developing and introducing new products and services that are appealing to our customers and end users with acceptable quality, prices and terms, we will not be able to compete effectively and our ability to generate revenues will suffer. The development of new products and services is very difficult and requires high

 

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levels of innovation. The development process is also lengthy and costly. If we fail to accurately anticipate technological trends or our end users’ needs or preferences or are unable to complete the development of products and services in a cost-effective and timely fashion, we will be unable to introduce new products and services into the market or successfully compete with other providers.

As we introduce new or enhanced products or integrate new technology into new or existing products, we face risks including, among other things, disruption in customers’ ordering patterns, excessive levels of older product inventories, delivering sufficient supplies of new products to meet customers’ demand, possible product and technology defects and a potentially different sales and support environment. Premature announcements or leaks of new products, features or technologies may exacerbate some of these risks. Our failure to manage the transition to newer products or the integration of newer technology into new or existing products could adversely affect our business, results of operations and financial condition.

Our products may contain errors or defects, which could result in the rejection or return of our products, damage to our reputation, lost revenues, diverted development resources and increased service costs, warranty claims and litigation.

Our products are complex and must meet stringent user requirements. In addition, we warrant that our products will be free of defect for 90 to 365 days after the date of purchase, depending on the product. In Europe, we are required in some countries to provide a two-year warranty for certain defects. In addition, certain of our contracts with wireless carriers include epidemic failure clauses with low thresholds that we have in some instances exceeded. If invoked, these clauses may entitle the wireless carrier to return or obtain credits for products in inventory or to cancel outstanding purchase orders.

In addition, we must develop our hardware and software application products quickly to keep pace with the rapidly changing mobile-product market, and we have a history of frequently introducing new products. Products as sophisticated as ours are likely to contain undetected errors or defects, especially when first introduced or when new models or versions are released. Our products may not be free from errors or defects after commercial shipments have begun, which could result in the rejection of our products, damage claims, litigation and recalls and jeopardize our relationship with wireless carriers. End users may also reject or find issues with our products and have a right to return them even if the products are free from errors or defects. In either case, returns or quality issues could result in damage to our reputation, lost revenues, diverted development resources, increased customer service and support costs, additional contractual obligations to wireless carriers and warranty claims and litigation which could harm our business, results of operations and financial condition.

If we are unable to compete effectively with existing or new competitors, we could experience price reductions, reduced demand for our products and services, reduced margins and loss of market share, and our business, results of operations and financial condition would be adversely affected.

The markets for our products are highly competitive, and we expect increased competition in the future, particularly as companies from established industry segments, such as mobile handset, personal computer and consumer electronics, enter these markets or increasingly expand and market their competitive product offerings or both.

Some of our competitors or potential competitors possess capabilities developed over years of serving customers in their respective markets that might enable them to compete more effectively than we compete in certain segments. In addition, many of our competitors have significantly greater engineering, technical, manufacturing, sales, marketing and financial resources and capabilities than we do. These competitors may be able to respond more rapidly than we can to new or emerging technologies or changes in customer requirements, including introducing a greater number and variety of products than we can. They may also be in a better position financially or otherwise to acquire and integrate companies and technologies that enhance their competitive positions and limit our competitiveness. In addition, they may devote greater resources to the development, promotion and sale of their products than we do. They may have lower costs and be better able to withstand

 

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lower prices in order to gain market share at our expense. They may also be more diversified than we are and better able to leverage their other businesses, products and services to be able to accept lower returns in the smartphone market and gain market share. Finally, these competitors may bring with them customer loyalties, which may limit our ability to compete despite superior product offerings.

Our devices compete with a variety of mobile devices. Our principal competitors include: mobile handset and smartphone manufacturers such as Apple, Asustek, HTC, LG, Motorola, Nokia, Pantech, RIM, Samsung and Sony-Ericsson; and computing device companies such as Acer, Hewlett-Packard and Mio Technology. In addition, our products compete for a share of disposable income and business spending on consumer electronic, telecommunications and computing products such as MP3 players, iPods, media/photo viewers, digital cameras, personal media players, digital storage devices, handheld gaming devices, GPS devices and other such devices.

Some of our competitors, such as Asustek and HTC, produce smartphones as wireless-carrier-branded devices in addition to their own branded devices. As technology advances, we also expect to compete with mobile phones without branded operating systems that synchronize with personal computers, as well as ultra-mobile personal computers and laptop computers with wide area network or data cards with VoIP, and WiFi phones with VoIP.

Some competitors sell or license server, desktop and/or laptop computing products, software and/or recurring services in addition to mobile products and may choose to market their mobile products at a discounted price or give them away for free with their other products or services, which could negatively affect our ability to compete.

A number of our competitors have longer and closer relationships with the senior management of business customers who decide which products and technologies will be deployed in their business. Many competitors have larger and more established sales forces calling on wireless carriers and business customers and therefore could contact a greater number of potential customers with more frequency. Consequently, these competitors could have a better competitive position than we do, which could result in wireless carriers and business customers deciding not to choose our products and services, which would adversely impact our revenues.

Successful new product introductions or enhancements by our competitors could cause intense price competition or make our products obsolete. To remain competitive, we must continue to invest significant resources in research and development, sales and marketing and customer support. We cannot be sure that we will have sufficient resources to make these investments or that we will be able to make the technological advances necessary to be competitive. Increased competition could result in price reductions, reduced demand for our products and services, increased expenses, reduced margins and loss of market share. Failure to compete successfully against current or future competitors could harm our business, results of operations and financial condition.

We are highly dependent on wireless carriers for the success of our smartphone products.

The success of our business strategy and our smartphone products is highly dependent on our ability to establish new relationships and build on our existing relationships with domestic and international wireless carriers. We cannot assure you that we will be successful in establishing new relationships, or maintaining or advancing existing relationships with wireless carriers or that these wireless carriers will act in a manner that will promote the success of our smartphone products. Factors that are largely within the control of wireless carriers, but which are important to the success of our smartphone products, include:

 

  ·  

testing of our smartphone products on wireless carriers’ networks;

 

  ·  

quality and coverage area of wireless voice and data services offered by the wireless carriers;

 

  ·  

the degree to which wireless carriers facilitate the introduction of and actively market, advertise, promote, distribute and resell our smartphone products;

 

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  ·  

the extent to which wireless carriers require specific hardware and software features on our smartphone products to be used on their networks;

 

  ·  

timely build-out of advanced wireless carrier networks that enhance the user experience for data-centric services through higher speed and “always on” functionality;

 

  ·  

contractual terms and conditions imposed on us by wireless carriers that, in some circumstances, could limit our ability to make similar products available through competitive wireless carriers in some market segments;

 

  ·  

wireless carriers’ pricing requirements and subsidy programs; and

 

  ·  

pricing and other terms and conditions of voice and data rate plans that the wireless carriers offer for use with our smartphone products.

For example, flat data rate pricing plans offered by some wireless carriers may represent some risk to our relationship with such wireless carriers. While flat data pricing helps customer adoption of the data services offered by wireless carriers and therefore highlights the advantages of the data applications of our smartphone products, such plans may not allow our smartphones to contribute as much average revenue per user to wireless carriers as when they are priced by usage, and therefore reduces our differentiation from other, non-data devices in the view of the wireless carriers. In addition, if wireless carriers charge higher rates than consumers are willing to pay, the acceptance of our wireless solutions could be less than anticipated and our revenues and results of operations could be adversely affected.

Wireless carriers have substantial bargaining power as we enter into agreements with them. They may require contract terms that are difficult for us to satisfy and could result in higher costs to complete certification requirements and negatively impact our results of operations and financial condition. Moreover, we do not have agreements with some of the wireless carriers with whom we do business internationally and, in some cases, the agreements may be with third-party distributors and may not pass through rights to us or provide us with recourse or contact with the wireless carrier. The absence of agreements means that, with little or no notice, these wireless carriers could refuse to continue to purchase all or some of our products or change the terms under which they purchase our products. If these wireless carriers were to stop purchasing our products, we may be unable to replace the lost sales channel on a timely basis and our results of operations could be harmed.

Wireless carriers also significantly affect our ability to develop and launch products for use on their wireless networks. If we fail to address the needs of wireless carriers, identify new product and service opportunities or modify or improve our smartphone products in response to changes in technology, industry standards or wireless carrier requirements, our products could rapidly become less competitive or obsolete. If we fail to timely develop smartphone products that meet wireless carrier product planning cycles or fail to deliver sufficient quantities of products in a timely manner to wireless carriers, those wireless carriers may choose to emphasize similar products from our competitors and thereby reduce their focus on our products which would have a negative impact on our business, results of operations and financial condition.

Wireless carriers, who control most of the distribution and sale of and virtually all of the access for smartphone products, could commoditize smartphones, thereby reducing the average selling prices and margins for our smartphone products which would have a negative impact on our business, results of operations and financial condition. In addition, if wireless carriers move away from subsidizing the purchase of smartphone products, this could significantly reduce the sales or growth rate of sales of smartphone products. This could have an adverse impact on our business, revenues and results of operations.

 

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We could be exposed to significant fluctuations in revenue for our smartphone products based on our strategic relationships with wireless carriers.

Because of their large sales channels, wireless carriers may purchase large quantities of our products prior to launch so that the products are widely available. Reorders of products may fluctuate quarter to quarter, depending on end-user demand and inventory levels required by the wireless carriers. As we develop new strategic relationships and launch new products with wireless carriers, our smartphone products-related revenue could be subject to significant fluctuation based on the timing of wireless carrier product launches, wireless carrier inventory requirements, marketing efforts and our ability to forecast and satisfy wireless carrier and end-user demand.

We are dependent on a concentrated number of significant customers and the loss or credit failure of any of those customers could have an adverse effect on our business, results of operations and financial condition.

Our three largest customers in terms of revenue represented 65% of our revenues during fiscal year 2008 compared to 56% during fiscal year 2007 and 55% during fiscal year 2006. We determine our largest customers in terms of revenue to be those who represent 10% or more of our total revenues for the year. We expect this trend of revenue concentration with our largest customers, particularly with wireless carriers, to continue. If any significant customer discontinues its relationship with us for any reason, or reduces or postpones current or expected purchases from us, it could have an adverse impact on our business, results of operations and financial condition.

In addition, our largest customers in terms of outstanding customer accounts receivable balances accounted for 61% of our accounts receivable at the end of fiscal year 2008 compared to 63% at the end of fiscal year 2007 and 66% at the end of fiscal year 2006. We determine our largest customers in terms of outstanding customer accounts to be those who have outstanding customer accounts receivable balances at the period end of 10% or more of our total net accounts receivables. We expect this trend of significant credit concentration with our largest customers, particularly with wireless carriers, to continue, concentrating our bad debt risks and the costs of mitigating those risks. We routinely monitor the financial condition of our customers and review the credit history of each new customer.

While we believe that our allowances for doubtful accounts adequately reflect the credit risk of our customers, as well as historical trends and other economic factors, we cannot assure you that such allowances will be accurate or sufficient. If any of our significant customers defaults on its account, or if we experience significant credit expense for any reason, it could have an adverse impact on our business, results of operations and financial condition.

If our products do not meet wireless carrier and governmental or regulatory certification or other requirements, we will not be able to compete effectively and our ability to generate revenues will suffer.

We are required to certify our products with governmental and regulatory agencies and with the wireless carriers for use on their networks and to meet other requirements. These processes can be time consuming, could delay the offering of our smartphone products on wireless carrier networks and could affect our ability to timely deliver products to customers. As a result, wireless carriers may choose to offer or consumers may choose to buy similar products from our competitors and thereby reduce their purchases of our products, which would have a negative impact on our smartphone products sales volumes, our revenues and our cost of revenues.

 

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If we do not correctly forecast demand for our products, we could have costly excess production or inventories or we may not be able to secure sufficient or cost-effective quantities of our products or production materials and our revenues, gross profit and financial condition could be adversely impacted.

The demand for our products depends on many factors, including pricing and channel inventory levels, and is difficult to forecast due in part to variations in economic conditions, changes in consumer and business preferences, relatively short product life cycles, changes in competition, seasonality and reliance on key sales channel partners. It is particularly difficult to forecast demand by individual product. Significant unanticipated fluctuations in demand, the timing and disclosure of new product releases or the timing of key sales orders could result in costly excess production or inventories or the inability to secure sufficient, cost-effective quantities of our products or production materials. This could adversely impact our revenues, gross profit and financial condition.

We depend on our suppliers, some of which are the sole source and some of which are our competitors, for certain components, software applications and elements of our technology, and our production or reputation could be harmed if these suppliers were unable or unwilling to meet our demand or technical requirements on a timely and/or a cost-effective basis.

Our products contain software and hardware, including liquid crystal displays, touch panels, memory chips, microprocessors, cameras, radios and batteries, which are procured from a variety of suppliers, including some who are our competitors. The cost, quality and availability of software and hardware are essential to the timely and successful development, production and sale of our device products. For example, components such as radio technologies and software such as email applications are critical to the functionality of our smartphones. Some components, such as liquid crystal displays and related integrated circuits, digital signal processors, microprocessors, radio frequency components and other discrete components, come from sole source suppliers. Alternative sources are not always available or may be prohibitively expensive. In addition, even when we have multiple qualified suppliers, we may compete with other purchasers for allocation of scarce components. Some components come from companies with whom we compete. If suppliers are unable or unwilling to meet our demand for components and if we are unable to obtain alternative sources or if the price for alternative sources is prohibitive, our ability to maintain timely and cost-effective production of our products will be harmed. Shortages may affect the timing and volume of production for some of our products as well as increase our costs due to premium prices paid for those components and longer-term commitments to ensure availability of those components. Some of our suppliers may be capacity-constrained due to high industry demand for some components and relatively long lead times to expand capacity.

Our product strategy is substantially dependent on the operating systems that we include in our devices and those operating systems face significant competition and may not be preferred by our wireless carrier partners or end users.

We provide a choice of operating systems for our smartphones to provide a differentiated experience for our users. Our smartphones currently feature either the Palm OS or Windows Mobile OS. In addition, we are developing a new OS that we expect to use in some of our future smartphones.

Our licenses to the Palm OS and Windows Mobile OS are subject to the terms of the agreements we have with ACCESS Systems Americas and Microsoft, respectively. Our business could be harmed if we were to breach the license agreements and cause our licensors to terminate our licenses. Furthermore, although ACCESS Systems and Microsoft offer some level of indemnification for damages arising from lawsuits involving their respective operating systems and from damages relating to intellectual property infringement caused by such operating systems, we could still be adversely affected by a determination adverse to our licensors, product changes that may be advisable or required due to such lawsuits or the failure of our licensors to indemnify us adequately.

 

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There is significant competition from makers of smartphones that differentiate their products in part through alternative OS software. A number of competitors offer alternative Windows Mobile OS products. Google is heading a group that has introduced the Android OS for which our competitors are developing products. The LiMo Foundation is another consortium that is developing a Linux-based mobile operating system. Other competitors have or are developing proprietary operating systems, including Apple’s OS X, Nokia’s Symbian OS, RIM’s OS and various Linux-based operating systems. These and other competitors could devote greater resources to the development and promotion of alternative operating systems and to the support of the third-party developer community, which could attract the attention of influential user segments and our existing and potential customers and end users. Moreover, some of our largest customers, including Verizon Wireless (a venture of Verizon Communications and Vodafone Group) and AT&T, have joined the consortiums developing or indicated their support for rival operating systems, including the LiMo Foundation and Android, respectively. Wireless carriers may demonstrate a preference for rival operating systems, thereby giving preference to our competitor’s products and making acceptance of our products more difficult among our key wireless carrier partners. In addition, this could require us to raise the performance and differentiation standards for the operating systems that we offer in order to remain competitive.

We cannot assure you that the operating systems we develop or license or our efforts to innovate using those operating systems will continue to draw the customer interest necessary to provide us with a level of competitive differentiation. If the use of the Palm OS, the Windows Mobile OS or proprietary operating systems incorporating open technologies in our current or future products does not continue to be competitive, our revenues and our results of operations could be adversely affected.

Our business is substantially dependent on our ability to develop our new operating system.

We are currently developing a new OS and related next-generation systems software for use in some of our future smartphones. We have announced that we expect this new OS and software to be completed in time to ship products based on this platform in the first half of calendar year 2009. If we are unable to develop the OS or related software on this timeline, or if the new OS and software is not accepted by our wireless carrier customers or end users, the robustness, competitiveness and technological viability of our smartphone product lines and our product roadmap would be adversely impacted. As a result, our reputation, ability to compete, revenues, results of operations and financial condition would also be adversely impacted. In addition, if the third-party developer community does not embrace the new OS and produce applications that will run on our smartphones, it may adversely affect acceptance of our devices by our wireless carrier customers and end users and adversely affect our ability to compete, our revenues and our results of operations.

If we are unable to obtain key technologies from third parties on a timely basis and free from errors or defects, we may have to delay or cancel the release of certain products or features in our products or incur increased costs.

We license third-party software for use in our products, including the Palm OS and Windows Mobile OS. Our ability to release and sell our products, as well as our reputation, could be harmed if the third-party technologies are not delivered to us in a timely manner, on acceptable business terms or contain errors or defects that are not discovered and fixed prior to release of our products and we are unable to obtain alternative technologies on a timely and cost effective basis to use in our products. As a result, our product shipments could be delayed, our offering of features could be reduced or we may need to divert our development resources from other business objectives, any of which could adversely affect our reputation, business and results of operations.

 

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The order issued by the International Trade Commission, or ITC, banning import of future models of 3G mobile broadband handsets containing chips, chipsets and software of Qualcomm Incorporated or other litigation between Qualcomm and Broadcom Corporation could hinder our ability to provide certain models of our smartphone products to our customers and to compete effectively, and could adversely affect our customer relationships, revenues, results of operations and financial condition.

The ITC has issued an order banning the import of future models of 3G mobile broadband handsets containing Qualcomm chips, chipsets and software after ruling that Qualcomm’s cellular chips, chipsets and software infringe on a Broadcom patent relating to power-saving technology. In addition, the ITC also issued a cease-and-desist order that prevents Qualcomm from engaging in certain activities within the United States related to the infringing chips. The banned chips, chipsets and software are used in handheld wireless communications devices that are capable of operating on 3G cellular telephone networks, such as EvDO and wCDMA networks operated by wireless carriers such as AT&T, Sprint and Verizon. An exception to the ban allows the import of handheld wireless communications devices that are of the same model as handheld wireless communications devices that were being imported for sale to the general public on or before June 7, 2007.

Palm filed an appeal of the ruling by the ITC with the Court of Appeals for the Federal Circuit, or CAFC. Palm requested the CAFC overturn the ITC Order as it relates to Palm products because Palm was not a party to the underlying ITC action and asked the CAFC to stay implementation of the Order. The CAFC granted Palm’s stay request until completion of the appeal.

Should Palm lose the appeal or were the stay lifted, our ability to import and sell certain models of our smartphone products containing the affected Qualcomm chips, chipsets, and software could be affected by several factors, including the scope of the exclusion on the import ban (for example, whether a particular model of a smartphone previously sold by us to a carrier before June 7, 2007 will be treated as a “new” model when it is launched with a different carrier after June 7, 2007) and the effectiveness of the workaround that Qualcomm has announced to avoid infringement of the Broadcom patent (for example, the workaround may require additional testing, certification and approval before it can be used for our smartphone products sold to carriers). In addition, the effectiveness of any workaround or other means of meeting the requirements of the import ban may be limited by Qualcomm’s ability to provide services and support in implementing the workaround or otherwise addressing the impact of the import ban.

The workaround and other means of addressing the import ban can be time consuming, can delay the offering of our smartphone products on carrier networks and also affect our ability to deliver products to customers in a timely manner. As a result, carriers may choose to offer, or consumers may choose to buy, unaffected products from our competitors and thereby reduce their purchases of our products, causing a negative impact on our smartphone products sales volumes, our revenues and our cost of revenues.

Qualcomm and Broadcom also continue to be engaged in litigation in at least two U.S. District Courts regarding Qualcomm’s chipsets and software used in wireless handsets and related support services. The outcome of these litigations may result in the non-availability of certain Qualcomm chipsets that we currently use or intend to use in our smartphones and/or related support services. Qualcomm is pursuing workarounds to avoid infringement of Broadcom’s patents but the ultimate success of any such workarounds is uncertain. An adverse outcome in any of these cases without an effective workaround could require modifications to our future smartphone roadmap, thereby delaying product introductions and adversely affect our customer relationships, revenues, results of operations and financial condition.

 

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We rely on third parties, some of which are our competitors, to design, manufacture, distribute, warehouse and support our products, and our reputation, revenues and results of operations could be adversely affected if these third parties fail to meet their performance obligations.

We outsource most of our hardware design and certain software development to third-party manufacturers, some of whom compete with us. We depend on their design expertise, and we rely on them to design our products at satisfactory quality levels. If our third-party manufacturers fail to provide quality hardware design or software development, our reputation and revenues could suffer. These third-party designers and manufacturers have access to our intellectual property which increases the risk of infringement or misappropriation of such intellectual property. In addition, these third parties may claim ownership rights in certain of the intellectual property developed for our products, which may limit our ability to have these products manufactured by others.

We outsource all of our manufacturing requirements to third-party manufacturers at their international facilities, which are located primarily in China, Taiwan and Brazil. In general our products are manufactured by sole source providers. We depend on these third parties to produce a sufficient volume of our products in a timely fashion and at satisfactory quality levels. In addition, we rely on our third-party manufacturers to place orders with suppliers for the components they need to manufacture our products and to track appropriately the shipment and inventory of those components with our orders. If they fail to place timely and sufficient orders with suppliers and appropriately maintain component inventories, our revenues and cost of revenues could suffer. Our reliance on third-party manufacturers in foreign countries exposes us to risks that are not in our control, including outbreaks of disease (such as an outbreak of bird flu), economic slowdowns, labor disruptions, trade restrictions, political conflicts and other events that could result in quarantines, shutdowns or closures of our third-party manufacturers or their suppliers. The cost, quality and availability of third-party manufacturing operations are essential to the successful production and sale of our products. If our third-party manufacturers fail to produce quality products on time and in sufficient quantities, our reputation, business and results of operations could suffer.

These manufacturers could refuse to continue to manufacture all or some of the units of our devices that we require or change the terms under which they manufacture our devices. If these manufacturers were to stop manufacturing our devices, we may be unable to replace the lost manufacturing capacity on a timely basis and our results of operations could be harmed. If these manufacturers were to change the terms under which they manufacture for us, our manufacturing costs and cost of revenues could increase. While we may have contractual remedies under manufacturing agreements, our business and reputation could be harmed. In addition, our contractual relationships are principally with the manufacturers of our products, and not with component suppliers. In the absence of a contract with the manufacturer that requires it to obtain and pass through warranty and indemnity rights with respect to component suppliers, we may not have recourse to any third party in the event of a component failure.

We may choose from time to time to transition to or add new third-party manufacturers. If we transition the manufacturing of any product to a new manufacturer, there is a risk of disruption in manufacturing and our revenues and results of operations could be adversely impacted. The learning curve and implementation associated with adding a new third-party manufacturer may adversely impact our revenues and results of operations.

We rely on third-party distribution and warehouse services providers to warehouse and distribute our products. Our contract warehouse facilities are physically separated from our contract manufacturing locations. This requires additional lead-time to deliver products to customers. If we are shipping products near the end of a fiscal quarter, this extra time could result in us not meeting anticipated shipment volumes for that quarter, which may negatively impact our revenues for that fiscal quarter. Any disruption of distribution facility services could have a negative impact on our revenues and results of operations.

As a result of economic conditions or other factors, our distribution and warehouse services providers may close or move their facilities with little notice to us, which could cause disruption in our ability to deliver products. With little or no notice, these distribution and warehouse services providers could refuse to continue to

 

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provide distribution and warehouse services for all or some of our devices, fail to provide the quality of services and security that we require or change the terms under which they provide such services. Any disruption of distribution and warehouse services could have a negative impact on our revenues and results of operations.

Changes in transportation schedules or the timing of deliveries due to shipping problems, wireless carrier financial difficulties, inaccurate forecasts of demand, acts of nature or other business interruptions could cause transportation delays and increase our costs for both receipt of inventory and shipment of products to our customers. If these types of disruptions occur, our reputation and results of operations could be adversely impacted.

We outsource most of the warranty support, product repair and technical support for our products to third-party providers, which are located around the world. We depend on their expertise, and we rely on them to provide satisfactory levels of service. If our third-party providers fail to provide consistent quality service in a timely manner and sustain customer satisfaction, our reputation and results of operations could suffer.

As a result of the credit agreement we entered into, we have a significant amount of debt. We may not be able to generate sufficient cash to service or repay all of our indebtedness, including the term loan, and we may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful. Our substantial indebtedness could adversely affect our business, results of operations and financial condition.

In October 2007, we entered into a credit agreement with JPMorgan Chase Bank, N.A. and Morgan Stanley Senior Funding, Inc., or the Credit Agreement, which governs a senior secured term loan in the aggregate principal amount of $400.0 million, or the Term Loan, and a credit facility in the aggregate principal amount of $30.0 million, or the Revolver. As a result of this Credit Agreement, we have significant indebtedness and substantial debt service requirements. Our ability to meet our payment and other obligations under our indebtedness depends on our ability to generate significant cash flows in the future. Our ability to generate cash is subject to our future operating performance and the demand for, and price levels of, our current and future products and services. However, our ability to generate cash is also subject to prevailing economic and competitive conditions and to general economic, financial, competitive, legislative, regulatory and other factors beyond our control. There is no assurance that our business will generate cash flows from operations, or that future borrowings will be available to us under our existing or any new credit facilities or otherwise, in an amount sufficient to enable us to meet our payment obligations under our indebtedness and to fund other liquidity needs. If our cash flows and capital resources are insufficient to fund our debt service or repayment obligations, we may be forced to reduce or delay capital expenditures, sell assets or operations, seek additional capital, restructure or refinance all or a portion of our indebtedness, including the Term Loan, or incur additional debt. There is no assurance that we would be able to take any of these actions on commercially reasonable terms or at all. There is also no assurance that these actions would be successful and permit us to meet our scheduled debt service or repayment obligations or that these actions would be permitted under the terms of our existing or future debt agreements. In the absence of such cash flow and capital resources, we could face substantial liquidity problems and might be required to dispose of material assets or operations to meet our debt service and other obligations. We may not be able to consummate those dispositions or to realize and obtain proceeds from them adequate to meet our debt service and other obligations. The Credit Agreement governing the Term Loan and Revolver restricts our ability to dispose of assets and use the proceeds from the disposition.

If we cannot make scheduled payments on our debt, or if we otherwise breach the Credit Agreement or related agreements, we will be in default and, as a result:

 

  ·  

our debt holders could declare all outstanding principal and interest to be due and payable;

 

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our debt holders could exercise their rights and remedies against the collateral securing their debt;

 

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we may trigger cross-acceleration and cross-default provisions under other agreements; and

 

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we could be forced into bankruptcy or liquidation.

 

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Although covenants contained in the Credit Agreement governing the Term Loan and the Revolver will limit our ability and the ability of certain of our present and future subsidiaries to incur certain additional indebtedness, these restrictions are subject to a number of qualifications and exceptions, and the indebtedness incurred in compliance with these restrictions could be substantial. In addition, the Credit Agreement will not prevent certain of our subsidiaries from incurring indebtedness. To the extent that we or our subsidiaries incur additional indebtedness, the related risks that we now face could intensify.

Our indebtedness may limit our ability to adjust to changing market conditions, place us at a competitive disadvantage compared to our competitors and adversely affect our business, results of operations and financial condition.

Restrictive covenants may adversely affect our operations.

The Credit Agreement governing the Term Loan and the Revolver contains covenants that may adversely affect our ability to, among other things, finance future operations or capital needs or engage in other business activities. Further, the Credit Agreement contains negative covenants limiting our ability and the ability of our subsidiaries, among other things, to incur debt, grant liens, make acquisitions, make certain restricted payments, make investments, sell assets and enter into sale and lease back transactions. Any additional debt we may incur in the future may subject us to further covenants. As a result of these covenants, we are limited in the manner in which we conduct our business and we may be unable to finance future operations or capital needs or engage in other business activities.

Even if we are able to comply with all of the applicable covenants, the restrictions on our ability to manage our business in our sole discretion could adversely affect our business by, among other things, limiting our ability to take advantage of financings, mergers, acquisitions and other corporate opportunities that we believe would be beneficial to us. Even if we were able to obtain new financing, it may not be on commercially reasonable terms, or terms that are acceptable to us.

Our ability to comply with covenants contained in the Credit Agreement governing the Term Loan and Revolver and any agreements governing other indebtedness may be affected by events beyond our control, including prevailing economic, financial and industry conditions. Our failure to comply with the covenants contained in any of the debt agreements described above, for any reason, could result in a default under such debt agreements. In addition, if any such default is not cured or waived, the default could result in an acceleration of debt under the Credit Agreement and our other debt instruments that contain cross-acceleration or cross-default provisions, which could require us to repay or repurchase debt, together with accrued interest, prior to the date it otherwise is due and that could adversely affect our financial condition. Upon a default or cross-default, the collateral agent, at the direction of the lenders under the Credit Agreement could proceed against the collateral, which includes substantially all of our assets.

Variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.

Under our Credit Agreement, our Term Loan and Revolver bear interest at variable rates and expose us to interest rate risk. If interest rates increase, our debt service obligations on the variable rate indebtedness would increase even though the principal amount of such indebtedness remained the same, and our operating results would decrease. Interest on the Term Loan is based on LIBOR or the Alternate Base Rate (higher of Prime Rate or Federal Funds Effective Rate plus 0.50%). An increase in the interest rate payable on the Term Loan could have an adverse effect on our results of operations, financial condition and cash flows, and our ability to make payments on the Term Loan, particularly if the increase is substantial.

 

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Third parties have claimed, and may claim in the future, that we are infringing their intellectual property, and we could suffer significant litigation or licensing expenses or be prevented from selling products regardless of whether these claims are successful.

In the course of our business, we frequently receive offers to license or claims of infringement of patents held by other parties. For example, as our focus has shifted to smartphone products, we have received, and expect to continue to receive communications from holders of patents related to mobile communication standards. We evaluate the validity and applicability of these patents and determine in each case whether we must negotiate licenses to incorporate or use implicated technologies in our products. Third parties may claim that our customers or we are infringing or contributing to the infringement of their intellectual property rights, and we may be found to infringe or contribute to the infringement of those intellectual property rights and may be required to pay significant damages and obligated either to refrain from the further sale of our products or to license the right to sell our products on an ongoing basis. We may be unaware of intellectual property rights of others that may cover some of our technology, products and services. We may not have direct contractual relationships with some of the component, software and applications providers for our products, and as a result, we may not have indemnification, warranties or other protection with respect to such components, software or applications. Furthermore, intellectual property claims against us or our suppliers may cause us or our customers to delay the introduction of or to stop using our devices or applications for our devices and, as a result, our revenue, business and results of operations may be adversely affected.

Any litigation regarding patents or other intellectual property could be costly and time consuming and could divert the attention of our management and key personnel from our business operations. The complexity of the technology involved and the uncertainty of litigation generally increase the risks associated with intellectual property litigation. Moreover, patent litigation has increased due to the increased numbers of cases asserted by intellectual property licensing entities as well as increasing competition and overlap of product functionality in our markets. Intellectual property licensing entities generally do not generate products or services. As a result, we cannot deter their infringement claims based on counterclaims that they infringe patents in our portfolio or by entering cross-licensing arrangements. Claims of intellectual property infringement may also require us to enter into costly royalty or license agreements or to indemnify our customers, licensees, ODMs and other third parties with whom we have relationships. However, we may not be able to obtain royalty or license agreements on terms acceptable to us or at all. We also may be subject to significant damages or injunctions against the development and sale of our products. These risks associated with patent litigation are exacerbated by the lack of a clear and consistent legal standard for assessing damages in such litigation.

We are subject to general commercial litigation and other litigation claims as part of our operations, and we could suffer significant litigation expenses in defending these claims and could be subject to significant damage awards or other remedies.

In the course of our business, we receive consumer protection claims, general commercial claims related to the conduct of our business and the performance of our products and services, employment claims and other litigation claims. Any litigation resulting from these claims could be costly and time-consuming and could divert the attention of our management and key personnel from our business operations. The complexity of the technology involved and the uncertainty of consumer, commercial, employment and other litigation increase these risks. We also may be subject to significant damages or equitable remedies regarding the development and sale of our products and operation of our business.

 

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Our success largely depends on our ability to hire, retain, integrate and motivate sufficient numbers of qualified personnel, including senior management. Our strategy and our ability to innovate, design and produce new products, sell products, maintain operating margins and control expenses depend on key personnel that may be difficult to replace.

Our success depends on our ability to attract and retain highly skilled personnel, including senior management and international personnel. From time to time, we experience turnover in some of our senior management positions. We compensate our employees through a combination of salary, bonuses, benefits and equity compensation. Recruiting and retaining skilled personnel, including software and hardware engineers, is highly competitive, particularly in the San Francisco Bay Area where we are headquartered. If we fail to provide competitive compensation to our employees, it will be difficult to retain, hire and integrate qualified employees and contractors and we may not be able to maintain and expand our business. If we do not retain our senior managers or other key employees for any reason, we risk losing institutional knowledge and experience, expertise and other benefits of continuity and the ability to attract and retain other key employees. In addition, we must carefully balance the growth of our employee base with our current infrastructure, management resources and anticipated revenue growth. If we are unable to manage the growth of our employee base, particularly software and hardware engineers, we may fail to develop and introduce new products successfully and in a cost effective and timely manner. If our revenue growth or employee levels vary significantly, our results of operations and financial condition could be adversely affected. Volatility or lack of positive performance in our stock price may also affect our ability to retain key employees, many of whom have been granted stock options, other equity incentives or both. Palm’s practice has been to provide equity incentives to its employees through the use of stock options and other equity vehicles, but the number of shares available for new options and other forms of securities grants is limited. We may find it difficult to provide competitive stock option grants or other equity incentives and our ability to hire, retain and motivate key personnel may suffer.

Recently and in past years, we have initiated reductions in our workforce of both employees and contractors to align our employee base with our anticipated revenue base or areas of focus and we have seen some turnover in our workforce. These reductions have resulted in reallocations of duties, which could result in employee and contractor uncertainty. Reductions in our workforce could make it difficult to attract, motivate and retain employees and contractors, which could affect our ability to deliver our products in a timely fashion and adversely affect our business.

We rely on third parties to sell and distribute our products, and we rely on their information to manage our business. Disruption of our relationship with these channel partners, changes in their business practices, their failure to provide timely and accurate information or conflicts among our channels of distribution could adversely affect our business, results of operations and financial condition.

The wireless carriers, distributors, retailers and resellers who sell and distribute our products also sell products offered by our competitors. If our competitors offer our sales channel partners more favorable terms or have more products available to meet their needs or utilize the leverage of broader product lines sold through the channel, those wireless carriers, distributors, retailers and resellers may de-emphasize or decline to carry our products. In addition, certain of our sales channel partners could decide to de-emphasize the product categories that we offer in exchange for other product categories that they believe provide higher returns. If we are unable to maintain successful relationships with these sales channel partners or to expand our distribution channels, our business will suffer.

Because we sell our products primarily to wireless carriers, distributors, retailers and resellers, we are subject to many risks, including risks related to product returns, either through the exercise of contractual return rights or as a result of our strategic interest in assisting them in balancing inventories. In addition, these sales channel partners could modify their business practices, such as inventory levels, or seek to modify their contractual terms, such as return rights or payment terms. Unexpected changes in product return requests, inventory levels, payment terms or other practices by these sales channel partners could negatively impact our business, results of operations and financial condition.

 

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We rely on wireless carriers, distributors, retailers and resellers to provide us with timely and accurate information about their inventory levels as well as sell-through of products purchased from us. We use this information as one of the factors in our forecasting process to plan future production and sales levels, which in turn influences our financial forecasts. We also use this information as a factor in determining the levels of some of our financial reserves. If we do not receive this information on a timely and accurate basis, our results of operations and financial condition may be adversely impacted.

Distributors, retailers and traditional resellers experience competition from Internet-based resellers that distribute directly to end users, and there is also competition among Internet-based resellers. We also sell our products to end users from our Palm.com website. These varied sales channels could cause conflict among our channels of distribution, which could harm our business, revenues and results of operations.

We rely on third parties to manage and operate our e-commerce web store and related telesales call center and disruption to these sales channels could adversely affect our revenues and results of operations.

We outsource the operations of our e-commerce web store and related telesales call centers to third parties. We depend on their expertise and rely on them to provide satisfactory levels of service. If these third-party providers fail to provide consistent quality service in a timely manner and sustain customer satisfaction, our operations and revenues could suffer. If these third-parties were to stop providing these services, we may be unable to replace them on a timely basis and our results of operations could be harmed. In addition, if these third parties were to change the terms and conditions under which they provide these services, our selling costs could increase.

We use third parties to provide significant operational and administrative services, and our ability to satisfy our customers and operate our business could suffer if the level of services is interrupted or does not meet our requirements.

We use third parties, some of which are our competitors, to provide services such as data center operations, desktop computer support, facilities services and certain accounting services. Should any of these third parties fail to deliver an adequate level of service on a timely basis, our business could suffer. Some of our operations rely on electronic data systems interfaces with third parties or on the Internet to communicate information. Interruptions in the availability and functionality of systems interfaces or the Internet could adversely impact the operations of these systems and consequently our results of operations.

The market for our products is volatile, and changing market conditions, or failure to adjust to changing market conditions, may adversely affect our revenues, results of operations and financial condition, particularly given our size, limited resources and lack of diversification.

Over the last few years, we have seen year-over-year declines in the volume of handheld computers while demand for smartphones has generally increased. We expect that the rate of declines in the volume of handheld computer units will continue. We cannot assure you that the smartphone market will continue to grow as forecasted. If we are unable to adequately respond to changes in demand for our products, our revenues and results of operations could be adversely affected. In addition, as our products and product categories mature and face greater competition, we may experience pressure on our product pricing to preserve demand for our products, which would adversely affect our margins, results of operations and financial condition.

This reliance on the success of and trends in our industry is compounded by the size of our organization and our focus on smartphones and related products. These factors also make us more dependent on investments of our limited resources. For example, we face many resource allocation decisions, such as: where to focus our research and development, geographic sales and marketing and partnering efforts; which aspects of our business to outsource; which operating systems and email solutions to support; and how to balance among our products. We have shifted the focus of our engineering resources towards the smartphone opportunity. Given the size and undiversified nature of our organization, any error in investment strategy could harm our business, results of operations and financial condition.

 

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Our products are subject to increasingly stringent laws, standards and other regulatory requirements, and the costs of compliance or failure to comply may adversely impact our business, results of operations and financial condition.

Our products must comply with a variety of laws, standards and other requirements governing, among other things, safety, materials usage, packaging and environmental impacts and must obtain regulatory approvals and satisfy other regulatory concerns in the various jurisdictions where our products are sold. Many of our products must meet standards governing, among other things, interference with other electronic equipment and human exposure to electromagnetic radiation. Failure to comply with such requirements can subject us to liability, additional costs and reputational harm and in severe cases prevent us from selling our products in certain jurisdictions. For example, many of our products are subject to laws and regulations that restrict the use of lead and other substances and require producers of electrical and electronic equipment to assume responsibility for collecting, treating, recycling and disposing of our products when they have reached the end of their useful life. Failure to comply with applicable environmental requirements can result in fines, civil or criminal sanctions and third-party claims. If products we sell in Europe are found to contain more than the permitted percentage of lead or another listed substance, it is possible that we could be forced to recall the products, which could result in substantial replacement costs, contract damage claims from customers, and reputational harm. We are now and expect in the future to become subject to additional requirements in the United States, China and other parts of the world.

As a result of these varying and developing requirements throughout the world, we are now facing increasingly complex procurement and design challenges, which, among other things, require us to incur additional costs identifying suppliers and contract manufacturers who can provide, and otherwise obtain, compliant materials, parts and end products and re-designing products so that they comply with these and the many other requirements applicable to them.

Allegations of health risks associated with electromagnetic fields and wireless communications devices, and the lawsuits and publicity relating to them, regardless of merit, could adversely impact our business, results of operations and financial condition.

There has been public speculation about possible health risks to individuals from exposure to electromagnetic fields, or radio signals, from base stations and from the use of mobile devices. While a substantial amount of scientific research by various independent research bodies has indicated that these radio signals, at levels within the limits prescribed by public health authority standards and recommendations, present no evidence of adverse effect to human health, we cannot assure you that future studies, regardless of their scientific basis, will not suggest a link between electromagnetic fields and adverse health effects. Government agencies, international health organizations and other scientific bodies are currently conducting research into these issues. In addition, other mobile device companies have been named in individual plaintiff and class action lawsuits alleging that radio emissions from mobile phones have caused or contributed to brain tumors and the use of mobile phones poses a health risk. Although our products are certified as meeting applicable public health authority safety standards and recommendations, even a perceived risk of adverse health effects from smartphones or other handheld devices could adversely impact use of such devices or subject us to costly litigation and could harm our reputation, business, results of operations and financial condition.

If third parties infringe our intellectual property or if we are unable to secure and protect our intellectual property, we may expend significant resources enforcing our rights or suffer competitive injury.

Our success depends in large part on our proprietary technology and other intellectual property rights. We have a significant investment in the rights to the Palm brand and related trademarks and will continue to invest in that brand and in our patent portfolio.

 

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We rely on a combination of patents, copyrights, trademarks and trade secrets, confidentiality provisions and licensing arrangements to establish and protect our proprietary rights. Our intellectual property, particularly our patents, may not provide us a significant competitive advantage. If we fail to protect or to enforce our intellectual property rights successfully, our competitive position could suffer, which could harm our results of operations.

Our pending patent and trademark applications for registration may not be allowed, or others may challenge the validity or scope of our patents or trademarks, including patent or trademark applications or registrations. Even if our patents or trademark registrations are issued and maintained, these patents or trademarks may not be of adequate scope or benefit to us or may be held invalid and unenforceable against third parties.

We may be required to spend significant resources to monitor and police our intellectual property rights. Effective policing of the unauthorized use of our products or intellectual property is difficult and litigation may be necessary in the future to enforce our intellectual property rights. Intellectual property litigation is not only expensive, but time-consuming, regardless of the merits of any claim, and could divert attention of our management from operating our business. Despite our efforts, we may not be able to detect infringement and may lose competitive position in the market before we do so. In addition, competitors may design around our technology or develop competing technologies. Intellectual property rights may also be unavailable or limited in some foreign countries, which could make it easier for competitors to capture market share.

In the past, there have been leaks of proprietary information associated with our intellectual property. We have implemented a security plan to reduce the risk of future leaks of proprietary information; however, we cannot assure you that the security plan will be able to prevent the risk of all leaks of proprietary information. In addition, we may not be successful in preventing those who have obtained our proprietary information through past leaks from using our technology to produce competing products or in preventing future leaks of proprietary information.

Despite our efforts to protect our proprietary rights, existing laws, contractual provisions and remedies afford only limited protection. Intellectual property lawsuits are subject to inherent uncertainties due to, among other things, the complexity of the technical issues involved, and we cannot assure you that we will be successful in asserting intellectual property claims. Attempts may be made to copy or reverse engineer aspects of our products or to obtain and use information that we regard as proprietary. Accordingly, we cannot assure you that we will be able to protect our proprietary rights against unauthorized third-party copying or use. The unauthorized use of our technology or of our proprietary information by competitors could have an adverse effect on our ability to sell our products.

We have an international presence in countries whose laws may not provide protection of our intellectual property rights to the same extent as the laws of the United States, which may make it more difficult for us to protect our intellectual property.

As part of our business strategy, we target customers and relationships with suppliers and ODMs in countries with large populations and propensities for adopting new technologies. However, many of these countries do not address to the same extent as the United States misappropriation of intellectual property or deter others from developing similar, competing technologies or intellectual property. Effective protection of patents, copyrights, trademarks, trade secrets and other intellectual property may be unavailable or limited in some foreign countries. As a result, we may not be able to effectively prevent competitors in these regions from infringing our intellectual property rights, which would reduce our competitive advantage and ability to compete in those regions and negatively impact our business.

 

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Our future results could be harmed by economic, political, regulatory and other risks associated with international sales and operations.

Because we sell our products worldwide and most of the facilities where our devices are manufactured, distributed and supported are located outside the United States, our business is subject to risks associated with doing business internationally, such as:

 

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changes in foreign currency exchange rates;

 

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changes in a specific country’s or region’s political or economic conditions, particularly in emerging markets;

 

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changes in international relations;

 

  ·  

trade protection measures and import or export licensing requirements;

 

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changes in or interpretation of tax laws;

 

  ·  

compliance with a wide variety of laws and regulations which may have civil and/or criminal consequences for us and our officers and directors who we indemnify;

 

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difficulty in managing widespread sales operations; and

 

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difficulty in managing a geographically dispersed workforce in compliance with diverse local laws and customs.

In addition, we are subject to changes in demand for our products resulting from exchange rate fluctuations that make our products relatively more or less expensive in international markets. If exchange rate fluctuations occur, our business and results of operations could be harmed by decreases in demand for our products or reductions in margins.

While we sell our products worldwide, we have limited experience with sales and marketing in some countries. There can be no assurance that we will be able to market and sell our products in all of our targeted international markets. If our international efforts are not successful, our business growth and results of operations could be harmed.

We may be required to record impairment charges in future quarters as a result of the decline in value of our investments in auction rate securities.

We hold a variety of interest bearing auction rate securities, or ARS, that represent investments in pools of assets, including commercial paper, collateralized debt obligations, credit linked notes and credit derivative products. These ARS investments were intended to provide liquidity via an auction process that resets the applicable interest rate at predetermined calendar intervals, allowing investors to either roll over their holdings or gain immediate liquidity by selling such interests at par. The recent uncertainties in the credit markets have affected all of our holdings in ARS investments and, during fiscal year 2008, auctions for our investments in these securities have failed to settle on their respective settlement dates. Consequently, the investments are not currently liquid and we will not be able to access these funds until a future auction of these investments is successful or a buyer is found outside of the auction process. We may decide to hold these investments for a long time or to sell them at a substantial discount if we need liquidity. Maturity dates for these ARS investments range from 2017 to 2052.

The valuation of our investment portfolio, including our investment in ARS, is subject to uncertainties that are difficult to predict. Factors that may impact its valuation include changes to credit ratings of the securities as well as to the underlying assets supporting those securities, rates of default of the underlying assets, underlying collateral value, discount rates, liquidity and ongoing strength and quality of credit markets.

 

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Although we currently have the ability and intent to hold these ARS investments until a recovery of the auction process or until maturity, if the current market conditions deteriorate further, or the anticipated recovery in market values does not occur, we may be required to record additional impairment charges in future quarters.

Our ability to utilize our net operating losses may be limited if we engage in transactions which bring cumulative change in ownership for Palm to 50% or more.

As a result of the recapitalization transaction with Elevation Partners, we experienced a change in our ownership of approximately 27% as of October 24, 2007. If over a rolling three-year period, the cumulative change in our ownership exceeds 50%, our ability to utilize our net operating losses to offset future taxable income may be limited. This would limit the net operating loss available to offset taxable income each year following the cumulative change in our ownership over 50%. In the event the usage of these net operating losses is subject to limitation and we are profitable, our earnings and cash flows could be adversely impacted due to our increased tax liability.

If we continue to experience net losses over an extended period of time, we may need to establish a valuation allowance on our deferred tax asset relating to our net operating loss carryforwards, which could adversely affect our results of operations.

During the past four quarters, we have generated domestic net operating loss carryforwards that resulted in an increase in our existing deferred tax assets. If the current trends and market conditions continue and if we continue to generate net operating losses, we may be in a cumulative loss position in fiscal year 2009 and will need to evaluate increasing the valuation allowance on our deferred tax assets. The key components of this evaluation are, among other things, considering all of the positive and negative evidence in existence at that time, including the cumulative results of operations in recent years, the nature of recent losses, forecasts of a return to profitability and the length of tax loss carryforward periods. We will continue to assess whether an increase in the valuation allowance is necessary each quarter by considering all of the positive and negative evidence in existence at that time and, depending upon the nature and weighting of such evidence, a substantial increase in the valuation allowance on our deferred tax assets may be required in the near term, which would adversely affect our results of operations.

We are subject to audit by the Internal Revenue Service and other taxing authorities. Any assessment arising from an audit and the cost of any related dispute could adversely affect our results of operations and financial condition.

Our operations are subject to income and transaction taxes in the United States and in multiple foreign jurisdictions and to review or audit by the Internal Revenue Service and state, local and foreign tax authorities. While we strongly believe our tax positions are compliant with applicable tax laws and regulations, our positions could be subject to dispute by the taxing authorities. Any such dispute could be costly and time-consuming and could divert the attention of our management and key personnel from our business operations.

We may need or find it advisable to seek additional funding which may not be available or which may result in substantial dilution of the value of our common stock.

We currently believe that our existing cash, cash equivalents and short-term investments will be sufficient to satisfy our anticipated operating cash requirements and debt service or repayment requirements for at least the next 12 months. We could be required to seek additional funding if our expectations are not met.

Even if our expectations are met, we may find it advisable to seek additional funding. If we seek additional funding, adequate funds may not be available on favorable terms, or at all. If adequate funds are not available on acceptable terms, or at all, we may be unable to adequately fund our business plans and it could have a negative effect on our business, results of operations and financial condition. In addition, if funds are available, the issuance of equity securities or securities convertible into equity could dilute the value of shares of our common stock and cause the market price to fall and the issuance of additional debt could impose restrictive covenants that could impair our ability to engage in certain business transactions.

 

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We may pursue strategic acquisitions and investments which could have an adverse impact on our business if they are unsuccessful.

We have made acquisitions in the past and will continue to evaluate other acquisition opportunities that could provide us with additional product or service offerings or with additional industry expertise, assets and capabilities. Acquisitions could result in difficulties integrating acquired operations, products, technology, internal controls, personnel and management teams and result in the diversion of capital and management’s attention away from other business issues and opportunities. If we fail to successfully integrate acquisitions, including timely integration of internal controls to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, our business could be harmed. In addition, our acquisitions may not be successful in achieving our desired strategic objectives, which would also cause our business to suffer. Acquisitions can also lead to large non-cash charges that can have an adverse effect on our results of operations as a result of write-offs for items such as acquired in-process research and development, impairment of goodwill or the recording of stock-based compensation. In addition, from time to time we make strategic venture investments in other companies that provide products and services that are complementary to ours. If these investments are unsuccessful, this could have an adverse impact on our results of operations and financial condition.

Business interruptions could adversely affect our business.

Our operations and those of our suppliers and customers are vulnerable to interruption by fire, hurricanes, earthquake, power loss, telecommunications failure, computer viruses, computer hackers, terrorist attacks, wars, military activity, labor disruptions, health epidemics and other natural disasters and events beyond our control. For example, a significant part of our third-party manufacturing is based in Taiwan, an area that has experienced earthquakes and is considered seismically active. In addition, the business interruption insurance we carry may not cover, in some instances, or be sufficient to compensate us fully for losses or damages—including, for example, loss of market share and diminution of our brand, reputation and customer loyalty—that may occur as a result of such events. Any such losses or damages incurred by us could have an adverse effect on our business.

Wars, terrorist attacks or other threats beyond our control could negatively impact consumer confidence, which could harm our operating results.

Wars, terrorist attacks or other threats beyond our control could have an adverse impact on the United States and world economy in general, and consumer confidence and spending in particular, which could harm our business, results of operations and financial condition.

Risks Related to the Securities Markets and Ownership of Our Common and Preferred Stock

Our common stock price may be subject to significant fluctuations and volatility.

The market price of our common stock has been subject to significant fluctuations since the date of our initial public offering. These fluctuations could continue. Among the factors that could affect our stock price are:

 

  ·  

quarterly variations in our operating results;

 

  ·  

changes in revenues or earnings estimates or publication of research reports by analysts;

 

  ·  

speculation in the press or investment community;

 

  ·  

strategic actions by us, our customers, our suppliers or our competitors, such as new product announcements, acquisitions or restructurings;

 

  ·  

actions by institutional stockholders or financial analysts;

 

  ·  

general market conditions; and

 

  ·  

domestic and international economic factors unrelated to our performance.

 

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The stock markets in general, and the markets for high technology stocks in particular, have experienced high volatility that has often been unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of our common stock.

Elevation Partners may exercise significant influence over Palm.

As of May 31, 2008, the Series B Preferred Stock owned by Elevation Partners and its affiliates is convertible into approximately 26% of our outstanding common stock on an as-converted basis and votes on an as-converted basis with our common stock on all matters other than the election of directors.

Subject to certain exceptions, Elevation Partners will be permitted under the terms of a stockholders’ agreement between Palm and Elevation Partners, or the Stockholders’ Agreement, to maintain its ownership interest in Palm in subsequent offerings. As a result, Elevation Partners may have the ability to significantly influence the outcome of any matter submitted for the vote of Palm stockholders. The terms of the Series B Preferred Stock and the Stockholders’ Agreement (other than the election of directors) provide that Elevation Partners will designate a percentage of Palm’s board of directors proportional to Elevation Partners’ ownership position in Palm. Elevation Partners may have interests that diverge from, or even conflict with, those of Palm or its stockholders.

Certain elements of our relationship with Elevation Partners and our executive officers may discourage other parties from trying to acquire Palm.

The ownership position and governance rights of Elevation Partners could discourage a third party from proposing a change of control or other strategic transaction concerning Palm. Also, employment arrangements with our executive officers provide for termination benefits, including acceleration of the vesting of certain equity awards if they terminate their employment for good reason following a change of control or within three months prior to a change of control of Palm. Further, in connection with certain change of control transactions in which Elevation Partners maintains a beneficial ownership percentage of at least 7.5% of the surviving entity, they are entitled to retain a seat on the board of directors of the surviving entity. As a result of these factors, our common stock could trade at prices that do not reflect a “takeover premium” to the same extent as do the stocks of similarly situated companies that do not have a stockholder with an ownership interest as large as Elevation Partners’ ownership interest.

We may not have the ability to finance the mandatory repurchase offer pursuant to the terms of the Series B Preferred Stock.

If certain change of control transactions occur, we will be required to make an offer to repurchase up to all of the then outstanding shares of Series B Preferred Stock, at the option and election of the holders thereof. We will have the option to pay the repurchase price in cash or, subject to certain conditions, publicly traded shares of the acquiring entity in the change of control transaction. The cash repurchase price per share is 101% of the liquidation preference. The repurchase price per share, if paid in publicly traded shares of the acquiring entity, is 105% of the liquidation preference. Our failure to pay the repurchase price in respect of all tendered shares for any reason, including the absence of funds legally available for such payment, would require us to pay conditional dividends, which represent a cash dividend at an annual rate equal to the prime rate of JPMorgan Chase Bank N.A. plus four percent, on each share of Series B Preferred Stock. Conditional dividends will accrue and cumulate until the date on which we pay the entire repurchase price, and will be payable quarterly. For so long as conditional dividends are accruing, neither we nor any of our subsidiaries may declare or pay any dividends on our common stock, or repurchase or redeem any shares of our common stock. This may adversely affect the rights of our existing stockholders and the market price of our common stock. These repurchase requirements may also delay or make it more difficult for others to obtain control of us.

 

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Provisions in our charter documents and Delaware law and our adoption of a stockholder rights plan may delay or prevent acquisition of us, which could decrease the value of shares of our common stock.

Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us without the consent of our Board of Directors. These provisions include a classified Board of Directors and limitations on actions by our stockholders by written consent. Delaware law also imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock (including Series B Preferred Stock outstanding on an as-converted basis). In addition, our Board of Directors has the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer. Although we believe these provisions provide for an opportunity to receive a higher bid by requiring potential acquirers to negotiate with our Board of Directors, these provisions apply even if the offer may be considered beneficial by some stockholders.

Our Board of Directors adopted a stockholder rights plan, pursuant to which we declared and paid a dividend of one right for each share of common stock outstanding as of November 6, 2000. Unless redeemed by us prior to the time the rights are exercised, upon the occurrence of certain events, the rights will entitle the holders to receive upon exercise of the rights shares of our preferred stock, or shares of an acquiring entity, having a value equal to twice the then-current exercise price of the right. The issuance of the rights could have the effect of delaying or preventing a change in control of us.

Item 1B.    Unresolved Staff Comments

None.

Item 2.    Properties

In July 2005, we moved into and currently utilize 347,144 square feet of leased space in Sunnyvale, California in three buildings which serve as our corporate headquarters. We lease research and development facilities in Dublin, Ireland and San Diego, California. We also lease sales and support offices domestically and internationally. We believe that existing facilities are suitable and adequate for our current needs and we are subleasing excess space in certain locations. If we require additional space, we believe that we will be able to secure such space on commercially reasonable terms without undue operational disruption.

Item 3.    Legal Proceedings

The information set forth in Note 20 of the consolidated financial statements of Part II, Item 8 of this Form  10-K is incorporated herein by reference.

Item 4.    Submission of Matters to a Vote of Security Holders

None.

 

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Part II

Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Our common stock has traded on the Nasdaq stock market since our initial public offering on March 2, 2000. Our stock symbol is PALM. The following table sets forth the high and low closing sales prices as reported on the Nasdaq stock market for the periods indicated:

 

     High    Low         High    Low

Fiscal Year 2008

        

Fiscal Year 2007

     

Fourth quarter

   $ 6.24    $ 4.55   

Fourth quarter

   $ 19.45    $ 15.58

Third quarter

   $ 6.89    $ 4.49   

Third quarter

   $ 18.30    $ 13.58

Second quarter

   $ 19.18    $ 6.51   

Second quarter

   $ 16.53    $ 13.99

First quarter

   $ 18.08    $ 13.86   

First quarter

   $ 18.67    $ 13.99

As of June 27, 2008, we had approximately 3,395 registered stockholders of record. Other than the $150 million cash dividend paid to 3Com in March 2000 from the proceeds of our initial public offering, we have not paid and do not anticipate paying cash dividends in the future.

In October 2007, we sold 325,000 shares of Series B Preferred Stock to the private-equity firm Elevation Partners, L.P. in exchange for $325.0 million. We utilized these proceeds, along with existing cash and the proceeds of $400.0 million of new debt, to finance a $9.00 per share one-time cash distribution of approximately $948.9 million to shareholders of record as of October 24, 2007, resulting in an approximately $9.00 per share decrease in our stock price during the second quarter of fiscal year 2008.

The following table summarizes employee stock repurchase activity for the three months ended May 31, 2008:

 

     Total
Number
of

Shares
Purchased
(1)
   Average
Price Paid
Per Share
   Total Number of Shares
Purchased as Part of a
Publicly Announced
Plan (2)
   Average
Price Paid
Per Share
   Approximate Dollar
Value of Shares that
May Yet be

Purchased under
the Plan (2)

March 1, 2008—March 31, 2008

   —      $   —      —      $  —    $ 219,037,247

April 1, 2008—April 30, 2008

   —        —      —         $ 219,037,247

May 1, 2008—May 31, 2008

   —        —      —         $ 219,037,247
                  
   —      $ —          —        
                  

 

(1)   During the three months ended May 31, 2008, the Company did not repurchase any shares of common stock. As of May 31, 2008, a total of approximately 298,000 restricted shares may still be repurchased.
(2)   In September 2006, the Company’s Board of Directors authorized a stock buyback program for the Company to repurchase up to $250.0 million of its common stock. The program does not have a specified expiration date. During the three months ended May 31, 2008 no shares were repurchased under the stock buyback program. As of May 31, 2008, $219.0 million remains available for future repurchase. We currently do not have any plans to repurchase shares under this stock repurchase program during fiscal year 2009.

 

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Item 6.    Selected Financial Data

The following selected consolidated financial data for each of the five years in the period ended May 31, 2008 have been derived from our audited financial statements. The fiscal year 2004 data reflects the classification of the operations of Palm’s operating platform and licensing business as discontinued operations, as required under accounting principles generally accepted in the United States, as a result of the distribution of shares of PalmSource to our stockholders in October 2003. The information set forth below is not necessarily indicative of results of future operations and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes to those statements included in Items 7 and 8 of Part II of this Form 10-K. Our fiscal year ends on the Friday nearest to May 31. For presentation purposes, the periods have been presented as ending on May 31. Fiscal years 2008, 2007, 2006, and 2004 each contained 52 weeks while fiscal year 2005 contained 53 weeks.

 

    As of and for the Years Ended May 31,  
    2008 (1) (2)     2007 (2)   2006 (3) (4)     2005 (4) (5)   2004 (4)(6)  
    (in thousands, except per share data)  

Consolidated Statements of Operations Data:

         

Revenues

  $ 1,318,691     $ 1,560,507   $ 1,578,509     $ 1,270,410   $ 949,654  

Cost of revenues

    916,810       985,369     1,058,083       880,358     677,365  

Operating income (loss)

    (126,045 )     70,058     105,311       77,528     (4,080 )

Income tax provision (benefit)

    (52,809 )     36,044     (219,523 )     14,144     6,091  

Income (loss) from continuing operations

    (105,419 )     56,383     336,170       66,387     (10,215 )

Loss from discontinued operations

    —         —       —         —       (11,634 )

Net income (loss)

    (105,419 )     56,383     336,170       66,387     (21,849 )

Accretion of series B redeemable convertible preferred stock

    5,516       —       —         —       —    

Net income (loss) applicable to common shareholders

  $ (110,935 )   $ 56,383   $ 336,170     $ 66,387   $ (21,849 )
                                   

Net income (loss) per common share—basic:

         

Continuing operations

  $ (1.05 )   $ 0.55   $ 3.33     $ 0.68   $ (0.13 )

Discontinued operations

    —         —       —         —       (0.15 )
                                   
  $ (1.05 )   $ 0.55   $ 3.33     $ 0.68   $ (0.28 )
                                   

Net income (loss) per common share—diluted:

         

Continuing operations

  $ (1.05 )   $ 0.54   $ 3.19     $ 0.65   $ (0.13 )

Discontinued operations

    —         —       —         —       (0.15 )
                                   
  $ (1.05 )   $ 0.54   $ 3.19     $ 0.65   $ (0.28 )
                                   

Shares used to compute net income (loss) per common share:

         

Basic

    105,891       102,757     100,818       96,971     79,373  

Diluted

    105,891       104,442     105,745       102,579     79,373  

Consolidated Balance Sheet Data:

         

Cash, cash equivalents and short-term investments

  $ 258,748     $ 546,685   $ 518,894     $ 362,699   $ 252,451  

Working capital

    128,740       456,624     452,927       231,060     142,698  

Total assets

    1,180,262       1,548,002     1,487,522       950,032     787,938  

Total convertible debt

    —         —       35,000       35,000     35,000  

Total current and long-term debt

    398,000       —       —         —       —    

Series B redeemable convertible preferred stock

    255,671       —       —         —       —    

Other non-current liabilities

    2,098       4,568     6,545       12,257     1,600  

Total stockholders’ equity

    111,020       1,062,411     983,905       581,023     491,534  

 

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(1)   In October 2007, we sold 325,000 shares of Series B Preferred Stock to the private-equity firm Elevation Partners in exchange for $325.0 million, of which $250.2 million was allocated to Series B Preferred Stock and reflects a discount of approximately $9.8 million related to issuance costs, with the remaining $65.0 million allocated to additional paid-in capital as a result of a beneficial conversion feature. On an as-converted basis, these shares represented approximately 26% of our voting shares outstanding as of May 31, 2008. We utilized these proceeds, along with existing cash and the proceeds of $400.0 million of new debt, to finance a $9.00 per share one-time cash distribution of approximately $948.9 million to shareholders of record as of October 24, 2007, or the Recapitalization Transaction. In connection with the Recapitalization Transaction, we have recorded approximately $5.5 million related to the accretion of Series B Preferred Stock for fiscal year 2008 and approximately $8.0 million related to a stock-based compensation charge for the modification of certain option awards to include anti-dilution provisions. Our fiscal year 2008 results also include charges of approximately $32.2 million as a result of the impairment of our investments in ARS and a $5.0 million patent acquisition cost, which are partially offset by a gain on sale of land of approximately $4.4 million.
(2)   Includes stock-based compensation expense under Statement of Financial Accounting Standards, or SFAS, No. 123(R), Share-Based Payment, which requires stock-based compensation expense to be recognized based on the grant date fair value. Periods prior to June 1, 2006, have not been restated to include the compensation charges associated with the provisions of SFAS No. 123(R).
(3)   Includes a $250.3 million reversal of our valuation allowance on our deferred tax assets based on our conclusion that it was more likely than not that our domestic deferred tax assets would be realized in the future and, accordingly, that it was appropriate to release the valuation allowance recorded against those deferred tax assets. In addition, fiscal year 2006 results included a $22.5 million legal settlement with Xerox Corporation and a benefit of approximately $11.7 million to cost of revenues as a result of negotiating more favorable intellectual property licensing terms than we had previously expected at May 31, 2005.
(4)   Cost of revenues includes “cost of revenues” and the applicable portion of “amortization of intangible assets”.
(5)   Includes employee separation costs of $3.1 million recorded for one-time payments to certain of our employees, including our former chief executive officer, and $0.3 million associated with unvested shares of Palm restricted stock and a portion of the unvested options to purchase shares of Palm common stock that had their vesting accelerated in connection with employee separation costs.
(6)   Includes results of operations of the acquired Handspring business as of October 29, 2003.

Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the consolidated financial statements and notes to those financial statements included in this Form 10-K. Our 52-53 week fiscal year ends on the Friday nearest to May 31. Fiscal years 2008, 2007 and 2006 each contained 52 weeks. For presentation purposes, the periods presented are shown as ending on May 31.

Overview and Executive Summary

Palm, Inc. is a leading provider of mobile products that enhance the lifestyles of individual users and business customers worldwide. Our leadership results from creating thoughtfully integrated technologies that better enable people to stay connected with their family, friends and colleagues, access and share the information that matters to them most and manage their daily lives on the go. Palm offers Treo and Centro smartphones, handheld computers and accessories through a network of wireless carriers, as well as retail and business outlets worldwide.

Our objective is to be the leader in mobile lifestyle products for individual users and business customers. To achieve this, we focus on the following strategies: differentiate our products through innovative software, inspiring industrial design and the seamless integration of hardware, system software, applications and services to deliver a delightful mobile user experience; deliver a range of product choices around open platforms; focus

 

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on our core competencies by using a leveraged model to develop, manufacture, distribute and support our products; and build a brand synonymous with a mobile lifestyle. 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 wireless 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 lifestyle 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 wireless 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 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, impairment of auction rate securities, 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 consolidated financial statements.

Revenue Recognition

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

 

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products 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). Price protection is estimated based on specific programs, expected usage and historical experience. Rebates are estimated based on specific programs, actual wireless carrier purchase volumes and the expected percentage of end users that will redeem their rebates, which is estimated based on historical experience. Rebate estimates are refined over the program period as actual results are experienced. We have accrued rebate obligations of $64.9 million as of May 31, 2008 which are included in other accrued liabilities. Actual claims for returns, price protection and rebates 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.

Allowance for Doubtful Accounts

The allowance for doubtful accounts is based on our assessment of the collectability 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.

Warranty Costs

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.

Royalty Obligations

We accrue for royalty obligations to certain technology and patent holders based on (1) unit shipments of our smartphones and handheld computers, (2) a percentage of applicable revenue for the net sales of products using certain software technologies or (3) 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 $43.7 million as of May 31, 2008, including estimated royalties of $34.5 million which are reported in other accrued liabilities. While the amounts ultimately

 

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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 May 31, 2008 or on the results reported for the year then ended; however, the effect of finalization of these agreements in the future may be significant to the period in which recorded.

Long-Lived Asset Impairment

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.

Goodwill and Intangible Asset Impairment

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 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 Impairment or 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.

Restructuring Costs

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 Valuation and Inventory Purchase Commitments

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.

Stock-Based Compensation

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.

 

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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 Treasury rates provided by the United States 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 in connection with the Recapitalization Transaction 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 per share distribution) and the strike prices of the affected awards (adjusted for the $9.00 per share distribution).

The Geometric Brownian Motion simulation model was utilized to determine the fair value of stock options, restricted stock units and restricted stock awards granted with market conditions, or performance of Palm’s stock price, in connection with the Recapitalization Transaction. This model was utilized 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.

Non-Current Auction Rate Securities

We hold a variety of interest bearing auction rate securities, or ARS, that represent investments in pools of assets, including commercial paper, collateralized debt obligations, credit linked notes and credit derivative products. These ARS investments were intended to provide liquidity via an auction process that resets the applicable interest rate at predetermined calendar intervals, allowing investors to either roll over their holdings or gain immediate liquidity by selling such interests at par. The recent uncertainties in the credit markets have affected all of our holdings in ARS investments and, during fiscal year 2008, auctions for our investments in these securities have failed to settle on their respective settlement dates. Consequently, the investments are not

 

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currently liquid and we will not be able to access these funds until a future auction of these investments is successful or a buyer is found outside of the auction process. Maturity dates for these ARS investments range from 2017 to 2052. We currently have the ability and intent to hold these ARS investments until a recovery of the auction process or until maturity.

Historically, the fair value of ARS investments approximated par value due to the frequent resets through the auction process. While we continue to earn interest on our ARS investments at the maximum contractual rate, these investments are not currently trading and therefore do not currently have a readily determinable market value. The estimated fair value of ARS no longer approximates par value.

We have used a discounted cash flow model to determine the estimated fair value of our investment in ARS as of May 31, 2008. The assumptions used in preparing the discounted cash flow model include estimates for interest rates, timing and amount of cash flows and expected holding periods of the ARS. Based on this assessment of fair value, as of May 31, 2008, we determined there was a decline in the fair value of our ARS investments of $44.7 million, of which $12.5 million was deemed temporary and $32.2 million was recognized as a pre-tax other-than-temporary impairment charge.

We review our impairments in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and related guidance issued by the Financial Accounting Standards Board, or FASB, and SEC in order to determine the classification of the impairment as “temporary” or “other-than-temporary”. A temporary impairment charge results in an unrealized loss being recorded in the other comprehensive income (loss) component of stockholders’ equity. Such an unrealized loss does not affect net income (loss) for the applicable accounting period. An other-than-temporary impairment charge is recorded as a realized loss in the consolidated statement of operations and reduces net income (loss) for the applicable accounting period. In evaluating the impairment of any individual ARS, we classified such impairment as temporary or other-than-temporary. The differentiating factors between temporary and other-than-temporary impairment are primarily the length of the time and the extent to which the market value has been less than cost, the financial condition and near-term prospects of the issuer and our current intent and ability to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value.

The valuation of our investment portfolio is subject to uncertainties that are difficult to predict. Factors that may impact its valuation include changes to credit ratings of the securities as well as to the underlying assets supporting those securities, rates of default of the underlying assets, underlying collateral value, discount rates, liquidity and ongoing strength and quality of credit markets.

Income Taxes

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 FASB Financial Interpretation, or FIN, No. 48, Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109. 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

 

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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.

 

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Results of Operations

Comparison of Fiscal Years Ended May 31, 2008 and 2007

Revenues

 

     Years Ended May 31,     Increase/
(Decrease)
 
     2008    % of Revenue     2007    % of Revenue    
     (dollars in thousands)  

Revenues

   $ 1,318,691    100.0 %   $ 1,560,507    100.0 %   $ (241,816 )

We derive our revenues from sales of our smartphones, handheld computers, add-ons and accessories. Revenues for fiscal year 2008 decreased approximately 15% from fiscal year 2007. Smartphone revenue was $1,125.6 million in fiscal year 2008 and decreased approximately 10% from $1,250.0 million in fiscal year 2007. Handheld revenue was $193.1 million in fiscal year 2008 and decreased 38% from $310.5 million in fiscal year 2007. During fiscal year 2008, net device units shipped were approximately 4,254,000 units at an average selling price of $303 per unit. During fiscal year 2007, net device units shipped were approximately 4,270,000 units at an average selling price of $354 per unit. Of this 15% decrease in revenues, approximately 14 percentage points resulted from the decrease in average selling price and approximately 1 percentage point resulted from the decrease in unit shipments and accessories sales. The decrease in our average selling price is a result of a shift in product mix during the year towards lower-priced Centro smartphone products and a reduction in the volume of certain of our Treo smartphone products which carry higher average selling prices. These factors were partially offset by a decrease in the provision for product return reserves attributable to lower return rates. 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. We expect our handheld business to continue to decline in fiscal year 2009.

International revenues were approximately 21% of worldwide revenues in fiscal year 2008, compared with approximately 25% in fiscal year 2007.

Of the 15% decrease in worldwide revenues for fiscal year 2008 as compared to the prior year, approximately 8 percentage points resulted from a decrease in United States revenues and 7 percentage points resulted from a decrease in international revenues. Average selling prices for our units decreased by 16% in the United States and by 11% internationally during fiscal year 2008 as compared to the prior year. The decrease in average selling prices in each region is primarily the result of a shift in product mix during the year towards lower-priced smartphone products and a reduction in the volume of certain of our smartphone products which carry higher average selling prices. Net unit devices shipped increased approximately 7% in the United States and decreased approximately 20% internationally compared to the prior year. The increase in net units sold in the United States is primarily the result of the success of our Centro 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 units as a result of the declining handheld market, coupled with a decrease in smartphone unit sales.

Cost of Revenues

 

     Years Ended May 31,     Increase/
(Decrease)
 
     2008    % of Revenue     2007    % of Revenue    
     (dollars in thousands)  

Cost of revenues

   $ 916,810    69.5 %   $ 985,369    63.1 %   $ (68,559 )

Cost of revenues principally consists of material and transformation costs to manufacture our products, OS and other royalty expenses, warranty and technical support costs, freight, scrap and rework costs, the cost of excess or obsolete inventory and manufacturing overhead which includes manufacturing personnel related costs, depreciation and allocated information technology and facilities costs. Cost of revenues as a percentage of

 

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revenues increased by 6.4 percentage points to 69.5% for fiscal year 2008 from 63.1% for fiscal year 2007. Of the increase in cost of revenues as a percentage of revenues, 3.3 percentage points resulted from a shift in product mix towards smartphone products with lower margins. The cost of warranty repairs increased 2.9 percentage points compared to fiscal year 2007 primarily due to a higher per unit repair cost, coupled with a shift in mix to smartphone products, which carry a higher per unit repair cost. An increase in freight charges resulted in a 0.4 percentage point increase in cost of revenues as a percentage of revenues as a result of expedited shipments and fuel surcharges. Additionally, cancellation charges from certain vendors resulted in a 0.4 percentage point increase in cost of revenues due to our lower-than-anticipated purchase volumes of certain components and technical service costs increased approximately 0.3 percentage points due to higher smartphone unit volumes with higher per unit call costs. These increased costs as a percentage of revenues were partially offset by a 1.1 percentage point decrease in OS royalty costs primarily because of a shift in mix towards Palm OS based smartphone products, which carry a lower average OS cost per unit than Windows Mobile powered smartphone products.

Sales and Marketing

 

     Years Ended May 31,     Increase/
(Decrease)
 
     2008    % of Revenue     2007    % of Revenue    
     (dollars in thousands)  

Sales and marketing

   $ 229,702    17.4 %   $ 248,685    15.9 %   $ (18,983 )

Sales and marketing expenses consist principally of advertising and marketing programs, salaries and benefits for sales and marketing personnel, sales commissions, travel expenses and allocated information technology and facilities costs. Sales and marketing expenses in fiscal year 2008 decreased approximately 8% from fiscal year 2007. The increase in sales and marketing expenses as a percentage of revenues is due to the decrease in our revenues. The decrease in sales and marketing expenses in absolute dollars is primarily due to the following factors. Employee-related and travel expenses decreased approximately $11.0 million resulting from a decrease in average headcount of approximately 40 employees, as well as a decrease in the recruiting of sales and marketing personnel and their related employment costs during fiscal year 2008 compared to the prior year. Consulting expenses, including outsourced operations of our retail stores, decreased approximately $3.5 million as a result of the closure of our retail stores during the third quarter of fiscal year 2008, partially offset by increased outsourcing to support our product launches. We experienced a decrease in our marketing development expenses with our wireless carrier customers of approximately $3.4 million as a result of lower overall carrier revenue compared to the prior year. We experienced a decrease of approximately $3.2 million in direct marketing expenses as a result of providing fewer smartphone units to our wireless carrier partners for demonstration purposes during fiscal year 2008 as compared to the year ago period. These decreases were partially offset by an increase in allocated costs of approximately $1.6 million as a result of higher information technology and facilities costs primarily due to software system implementations and related depreciation. In addition, we experienced an increase in marketing, advertising and trade show costs of approximately $0.9 million due to an increased focus on our brand and Centro smartphones marketing campaigns, partially offset by our participation in fewer trade show events and the streamlining of other advertising efforts during the year.

Research and Development

 

     Years Ended May 31,     Increase/
(Decrease)
     2008    % of Revenue     2007    % of Revenue    
     (dollars in thousands)

Research and development

   $ 202,764    15.4 %   $ 190,952    12.2 %   $ 11,812

Research and development expenses consist principally of employee-related costs, third-party development costs, program materials, depreciation and allocated information technology and facilities costs. Research and development expenses during fiscal year 2008 increased approximately 6% from the comparable period a year

 

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ago. The increase in research and development expenses as a percentage of revenues and in absolute dollars during fiscal year 2008 is due to several factors. Higher information technology and facilities costs resulted in an increase of allocated costs of approximately $7.1 million over the prior year, primarily due to software system implementations and related depreciation. Outsourced engineering, consulting and project material costs increased approximately $2.3 million, reflecting increased costs related to product certifications with wireless carriers coupled with increased preproduction builds relative to the same period last year. This was partially offset by a more streamlined engineering process during the current year, which was primarily driven by our effort to focus on developing a single Palm software platform. An increase in employee-related expenses of approximately $1.2 million is primarily due to an increase in employment incentive compensation partially offset by a decrease in variable compensation as a result of not meeting our operational objectives for fiscal year 2008. Stock-based compensation increased approximately $1.2 million which is primarily the result of a $1.5 million charge taken for the modifications made to certain stock option plans in connection with the Recapitalization Transaction, partially offset by the result of lower weighted-average fair value assumptions for the year.

General and Administrative

 

     Years Ended May 31,     Increase/
(Decrease)
     2008    % of Revenue     2007    % of Revenue    
     (dollars in thousands)

General and administrative

   $ 60,778    4.6 %   $ 59,762    3.8 %   $ 1,016

General and administrative expenses consist principally of employee-related costs, travel expenses and allocated information technology and facilities costs for finance, legal, human resources and executive functions, outside legal and accounting fees, provision for doubtful accounts and business insurance costs. General and administrative expenses during fiscal year 2008 increased approximately 2% from the comparable period a year ago. The increase in general and administrative expenses in absolute dollars and as a percentage of revenues during fiscal year 2008 is due to several factors. Higher information technology and facilities costs resulted in an increase of allocated costs of approximately $1.4 million, primarily due to software system implementations and related depreciation. Additionally, an increase in employee-related expenses of approximately $0.6 million was primarily the result of increased recruiting fees for key management positions. These increases were partially offset by a decrease in professional and legal expenses of approximately $6.6 million, primarily as a result of lower costs for legal settlements and defense of patent litigation during fiscal year 2008. Stock-based compensation expense increased by approximately $5.6 million, which is the result of a $5.3 million charge taken for the modification made to certain stock option plans in connection with the Recapitalization Transaction coupled with a higher average balance of outstanding stock-based awards, partially offset by the result of lower weighted-average fair value assumptions for the year.

Amortization of Intangible Assets

 

     Years Ended May 31,     Increase/
(Decrease)
     2008    % of Revenue     2007    % of Revenue    
     (dollars in thousands)

Amortization of intangible assets

   $ 3,775    0.3 %   $ 1,981    0.1 %   $ 1,794

The increase in amortization of intangible assets in absolute dollars and as a percentage of revenues for fiscal year 2008 is due to a higher average balance of intangible assets during fiscal year 2008 as compared to the prior year.

 

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Patent Acquisition Cost

 

     Years Ended May 31,     Increase/
(Decrease)
     2008    % of Revenue     2007    % of Revenue    
     (dollars in thousands)

Patent acquisition cost

   $ 5,000    0.4 %   $   —      —   %   $ 5,000

During the first quarter of fiscal year 2008, we acquired patents and patent applications for $5.0 million. These patents and patent applications were acquired for strategic purposes in order to more effectively respond to intellectual property claims which may arise in the course of our business and, as of that date, were not acquired directly for the purpose of incorporating specific features into future products or for specific features in current products for which we currently pay or expect to pay royalties. Accordingly, the acquisition cost was expensed during the period of acquisition.

Restructuring Charges

 

     Years Ended May 31,     Increase/
(Decrease)
     2008    % of Revenue     2007    % of Revenue    
     (dollars in thousands)

Restructuring charges

   $ 30,353    2.3 %   $   —      —   %   $ 30,353

Restructuring charges relate to the implementation of a series of reorganization actions taken to streamline our business structure. Restructuring charges recorded during fiscal year 2008 of approximately $30.4 million consist of approximately $14.7 million related to restructuring actions taken during the third quarter of fiscal year 2008, approximately $5.9 million related to restructuring actions taken during the second quarter of fiscal year 2008 and approximately $10.1 million related to restructuring actions taken during the first quarter of fiscal year 2008. These fiscal year 2008 restructuring actions were partially offset by adjustments of $0.2 million related to restructuring actions taken during the fourth quarter of fiscal year 2001 as a result of more current information regarding future estimated sublease income and $0.1 million related to restructuring actions taken in connection with the Handspring acquisition which is now complete.

 

  ·  

The third quarter of fiscal year 2008 restructuring actions included charges of approximately $7.7 million related to workforce reductions across all geographic regions, primarily related to severance, benefits and related costs due to the reduction of approximately 130 regular employees and approximately $7.0 million related to facilities and property and equipment that would be disposed of or removed from service in fiscal year 2008, including the closure of our retail stores. This facilities and property and equipment charge includes approximately $4.5 million related to property and equipment disposed of or removed from service and other charges related to the closure of our retail stores and approximately $2.5 million for lease commitments for facilities no longer in service. We took these restructuring actions to better align our cost structure with current revenue expectations.

Our third quarter of fiscal year 2008 restructuring actions are expected to be substantially completed by the third quarter of fiscal year 2009. When complete, these actions are expected to result in annual expense reductions of at least $15.2 million related to compensation reductions, all of which are expected to have a positive impact on cash flows in future years. As of May 31, 2008, cash payments totaling approximately $7.0 million related to workforce reductions and $2.0 million related to facilities and property and equipment had been made related to these actions.

 

  ·  

The second quarter of fiscal year 2008 restructuring actions included project cancellation costs relating to the Foleo mobile companion product and discontinued development projects of approximately $5.9 million. Restructuring charges were a result of our decision to focus our efforts on developing a single Palm software platform and to offer a consistent user experience centered on the new platform.

 

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Our second quarter of fiscal year 2008 restructuring actions are expected to be substantially completed by the second quarter of fiscal year 2009. As of May 31, 2008, cash payments of approximately $3.9 million have been made related to these actions.

 

  ·  

The first quarter of fiscal year 2008 restructuring actions included charges of approximately $9.4 million related to workforce reductions, including approximately $1.1 million related to stock-based compensation as a result of the acceleration of certain awards and approximately $8.3 million for other severance, benefits and related costs and approximately $0.7 million relating to property and equipment disposed of or removed from service. The excess facilities and equipment costs were recognized for lease commitments, payable over approximately three years, offset by estimated sublease proceeds of approximately $0.5 million. Workforce reductions for the restructuring actions begun in the first quarter of fiscal year 2008 affected approximately 120 regular employees primarily in the United States. We took these restructuring actions to better align our cost structure with current revenue expectations.

Our first quarter of fiscal year 2008 restructuring actions are complete except for remaining contractual payments for excess facilities. These actions are expected to result in annual expense reductions of at least $15.0 million related to compensation reductions, all of which are expected to have a positive impact on cash flows in future years. As of May 31, 2008, cash payments totaling approximately $8.3 million related to workforce reductions and $0.1 million related to facilities and property and equipment had been made related to these actions.

Gain on Sale of Land

 

     Years Ended May 31,     Increase/
(Decrease)
 
     2008     % of Revenue     2007    % of Revenue    
     (dollars in thousands)  

Gain on sale of land

   $ (4,446 )   (0.3 )%   $   —      —   %   $ (4,446 )

In August 2005, we entered into an agreement with a real-estate broker to market for sale the 39 acres of land owned by Palm in San Jose, California. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we reclassified the land as land held for sale at that time. The sale closed during the first quarter of fiscal year 2008 and we received proceeds from the sale of land of approximately $64.5 million and recognized a gain on the sale, net of closing costs, of approximately $4.4 million.

In-process Research and Development

 

     Years Ended May 31,     Increase/
(Decrease)
 
     2008    % of Revenue     2007    % of Revenue    
     (dollars in thousands)  

In-process research and development

   $   —      —   %   $ 3,700    0.2 %   $ (3,700 )

In-process research and development for fiscal year 2007 in absolute dollars was the result of the acquisition of assets completed during the third quarter of fiscal year 2007 which included purchased in-process research and development that had not yet reached technological feasibility, had no alternative future use and was charged to operations.

 

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Impairment of Non-Current Auction Rate Securities

 

     Years Ended May 31,     Increase/
(Decrease)
     2008     % of Revenue     2007    % of Revenue    
     (dollars in thousands)

Impairment of non-current auction rate securities

   $ (32,175 )   (2.4 )%   $   —      —   %   $ 32,175

Impairment of non-current auction rate securities for fiscal year 2008 reflects an impairment charge of $32.2 million recognized on our non-current auction rate securities. These non-current auction rate securities are interest bearing and represent investments in pools of assets, including commercial paper, collateralized debt obligations, credit linked notes and credit derivative products. We have used a discounted cash flow model to determine the estimated fair value of our investments in ARS as of May 31, 2008. The assumptions used in preparing the discounted cash flow model include estimates for interest rates, timing and amount of cash flows and expected holding periods of the ARS. Based on this assessment of fair value, as of May 31, 2008 we determined there was a decline in the fair value of our ARS investments of $44.7 million, of which $12.5 million was deemed temporary and $32.2 million was recognized as a pre-tax other-than-temporary impairment charge.

The valuation of our investment portfolio is subject to uncertainties that are difficult to predict. Factors that may impact its valuation include changes to credit ratings of the securities as well as to the underlying assets supporting those securities, rates of default of the underlying assets, underlying collateral value, discount rates, liquidity and ongoing strength and quality of credit markets.

If the current market conditions deteriorate further, or the anticipated recovery in market values does not occur, we may be required to record additional impairment charges in future quarters.

We continue to monitor the market for ARS and consider its impact, if any, on the fair value of our ARS investments.

Interest (Expense)

 

     Years Ended May 31,     Increase/
(Decrease)
     2008     % of Revenue     2007     % of Revenue    
     (dollars in thousands)

Interest (expense)

   $ (20,397 )   (1.5 )%   $ (1,970 )   (0.1 )%   $ 18,427

Interest expense during fiscal year 2008 increased as a result of the higher outstanding debt balance as compared to the fiscal year 2007. Following the closing of the Recapitalization Transaction during the second quarter of fiscal year 2008, we increased our outstanding debt balance by $400.0 million.

Interest Income

 

     Years Ended May 31,     Increase/
(Decrease)
 
     2008    % of Revenue     2007    % of Revenue    
     (dollars in thousands)  

Interest income

   $ 21,860    1.7 %   $ 25,958    1.7 %   $ (4,098 )

The overall decrease in interest income in absolute dollars is due to a lower average cash and short-term investment balance during fiscal year 2008 as compared to fiscal year 2007.

Other Income (Expense), Net

 

     Years Ended May 31,     Increase/
(Decrease)
 
     2008     % of Revenue     2007     % of Revenue    
     (dollars in thousands)  

Other income (expense), net

   $ (1,471 )   (0.1 )%   $ (1,619 )   (0.1 )%   $ (148 )

Other income (expense) for fiscal years 2008 and 2007 consisted of bank and other miscellaneous charges and net gains on sales of investments. The change compared to fiscal year 2007 is not significant.

 

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Income Tax Provision (Benefit)

 

     Years Ended May 31,     Increase/
(Decrease)
 
     2008     % of Revenue     2007    % of Revenue    
     (dollars in thousands)  

Income tax provision (benefit)

   $ (52,809 )   (4.0 )%   $ 36,044    2.3 %   $ (88,853 )

The income tax benefit for fiscal year 2008 was $52.8 million, which consisted of federal, state and foreign income taxes and represents an effective tax rate of 33%. This rate differs from the amount computed by applying the federal statutory income tax rate primarily due to state taxes, foreign income taxed at different rates, non-deductible stock-based compensation expense, an increase in our valuation allowance primarily related to non-deductible impairment charges of certain investments and the recognition of previously unrecognized tax benefits.

Although we have determined that a valuation allowance is not required with respect to most of our domestic net operating loss carryforwards, deferred expenses and tax credit carryforwards, recovery is dependent on achieving the forecast of future operating income over a protracted period of time. As of May 31, 2008, we would require approximately $1,058 million in cumulative future operating income to be generated at various times over approximately the next 15-20 years to realize our net deferred tax assets. Based upon our projections, our current net operating loss, or NOL, and tax credit carryforwards will be fully utilized before they expire. We will evaluate the need for an increase in the valuation allowance of our deferred tax assets on a quarterly basis based on our cumulative results of operations in recent years and our anticipated results in future periods. A significant negative factor in the evaluation is cumulative losses in recent years and we may reach that position during fiscal year 2009. The assessment of whether an increase in the valuation allowance is necessary will be made each quarter by considering all of the positive and negative evidence in existence at that time and, depending upon the nature and weighting of such evidence, a substantial increase in the valuation allowance may be required to reduce the deferred tax assets. Any increase in a valuation allowance would result in additional income tax expense and could have a significant impact on our earnings in future periods.

The income tax provision for fiscal year 2007 was $36.0 million, which consisted of federal, state and foreign income taxes and represented an effective tax rate of 39%. This rate differed from the statutory U.S. rate due to lack of tax benefits from foreign losses offset in part by research tax credits.

Comparison of Fiscal Years Ended May 31, 2007 and 2006

Revenues

 

    Years Ended May 31,     Increase/
(Decrease)
 
    2007   % of Revenue     2006   % of Revenue    
    (dollars in thousands)  

Revenues

  $ 1,560,507   100.0 %   $ 1,578,509   100.0 %   $ (18,002 )

Revenues for fiscal year 2007 decreased approximately 1% from fiscal year 2006. Smartphone revenue was $1,250.0 million in fiscal year 2007 and increased 15% from $1,088.3 million in fiscal year 2006. Handheld revenue was $310.5 million in fiscal year 2007 and decreased 37% from $490.2 million in fiscal year 2006. During fiscal year 2007, net device units shipped were approximately 4,270,000 units at an average selling price of $354 per unit. During fiscal year 2006, net device units shipped were approximately 4,749,000 units at an average selling price of $316 per unit. Of this 1% decrease in revenues, net unit shipments and accessories sales decreased approximately 12 percentage points offset by an increase in average selling prices contributing approximately 11 percentage points. The decrease in net unit shipments was due to a decrease in handheld unit sales of approximately 35% year-over-year, partially offset by the increase in higher volume of smartphone unit sales of approximately 17% year-over-year. This increase of smartphone unit sales reflected an increase of smartphone sell-through of 34% year-over-year. The increase in average selling price reflected a continued shift towards smartphones during fiscal year 2007, which carried a higher average selling price. In addition, average selling price was affected by a greater mix of recently introduced products at higher average selling prices.

 

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International revenues were approximately 25% of worldwide revenues in fiscal year 2007, compared with approximately 24% in fiscal year 2006.

International revenues increased by 1 percentage point compared to a decrease in United States revenues of 2 percentage points, resulting in a 1% decrease in worldwide revenues for fiscal year 2007 as compared to fiscal year 2006. Average selling prices for our devices increased in the United States and internationally by 9% and 20%, respectively, during fiscal year 2007 as compared to fiscal year 2006. The increase in average selling prices in the United States was primarily the result of a greater mix of recently introduced products at higher average selling prices. The increase in the average selling price internationally was primarily the result of a shift towards smartphones, which carry a higher average selling price. Net units sold decreased approximately 10% in the United States and decreased approximately 11% internationally. The decrease in net unit sales in the United States and internationally was primarily the result of a decline in unit sales of our handheld computers which was partially offset by an increase in smartphone unit sales.

Total Cost of Revenues

 

     Years Ended May 31,     Increase/
(Decrease)
 
     2007    % of Revenue     2006    % of Revenue    
     (dollars in thousands)  

Cost of revenues

   $ 985,369    63.1 %   $ 1,057,708    67.0 %   $ (72,339 )

Applicable portion of amortization of intangible assets

     —      —         375    —         (375 )
                                  

Total cost of revenues

   $ 985,369    63.1 %   $ 1,058,083    67.0 %   $ (72,714 )

“Total cost of revenues” was comprised of “Cost of revenues” and the applicable portion of “Amortization of intangible assets” as shown in the table above. “Cost of revenues” as a percentage of revenues decreased by 3.9 percentage points to 63.1% for fiscal year 2007 from 67.0% for fiscal year 2006. The decrease was primarily the result of approximately 1.8 percentage points of lower product costs related to a shift in product mix. In addition, we experienced a 1.6 percentage point decrease in warranty expenses due to lower per unit repair costs during fiscal year 2007 as compared to fiscal year 2006. We also experienced a 0.3 percentage point decrease in OS royalty rates primarily because the quarterly amortization costs of the ACCESS license agreement entered into in December 2006 was less than the per-unit royalty costs under the previous agreement. Excess and obsolete inventory costs also decreased by 0.1 percentage points due to a reduction in our provision for end-of-life products during fiscal year 2007 as compared to fiscal year 2006. In addition, we experienced reduced manufacturing spending rates during fiscal year 2007, compared to fiscal year 2006, contributing approximately 0.1 percentage points, as a result of reduced depreciation costs as older equipment had become fully depreciated.

The “Amortization of intangible assets” applicable to the cost of revenues decreased in absolute dollars during fiscal year 2007 compared to fiscal year 2006 due to the intangible assets acquired in the Handspring acquisition becoming fully amortized in fiscal year 2006.

Sales and Marketing

 

     Years Ended May 31,     Increase/
(Decrease)
     2007    % of Revenue     2006    % of Revenue    
     (dollars in thousands)

Sales and marketing

   $ 248,685    15.9 %   $ 205,794    13.0 %   $ 42,891

Sales and marketing expenses in fiscal year 2007 increased approximately 21% from fiscal year 2006. The increase in sales and marketing expenses as a percentage of revenues and in absolute dollars was due to several factors. Product promotional programs and advertising increased approximately $26.2 million as a result of increased product advertising related to product launches, a branding campaign during the second half of fiscal

 

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year 2007 and also as a result of units provided to our wireless carrier partners for product certification and demonstration purposes. Consulting services increased $5.7 million to support our web store activities. We also experienced an increase in employee related expenses of approximately $5.7 million primarily resulting from an increased average number of sales and marketing employees during fiscal year 2007 compared to the prior year and associated travel and related costs to support our increased sales and marketing activity. Facilities costs and allocated information technology costs increased by approximately $0.6 million during fiscal year 2007 as a result of the increased average headcount. These increases were partially offset by reduced marketing development expenses of $0.8 million as a result of our decreased handheld revenues. Stock-based compensation expense increased $5.4 million during fiscal year 2007 as a result of the adoption of SFAS No. 123(R).

Research and Development

 

     Years Ended May 31,     Increase/
(Decrease)
     2007    % of Revenue     2006    % of Revenue    
     (dollars in thousands)

Research and development

   $ 190,952    12.2 %   $ 136,243    8.6 %   $ 54,709

Research and development expenses during fiscal year 2007 increased approximately 40% from fiscal year 2006. The increase in research and development expenses as a percentage of revenues and in absolute dollars during fiscal year 2007 was due to several factors. We experienced an increase in outsourced engineering, data communications and project material costs of approximately $17.5 million, reflecting our efforts in the development of our smartphone and mobile companion products. Employee-related expenses increased approximately $15.2 million due to approximately 130 additional employees hired to support our commitment to the development of smartphone products. In addition, consulting expenses increased by approximately $8.3 million to further support our efforts in the smartphone space. Allocated information technology costs increased approximately $4.9 million as a result of increased research and development headcount. Stock-based compensation expense increased $9.0 million during fiscal year 2007 as a result of the adoption of SFAS No. 123(R).

General and Administrative

 

     Years Ended May 31,     Increase/
(Decrease)
     2007    % of Revenue     2006    % of Revenue    
     (dollars in thousands)

General and administrative

   $ 59,762    3.8 %   $ 44,297    2.8 %   $ 15,465

General and administrative expenses during fiscal year 2007 increased approximately 35% from fiscal year 2006. The increase in general and administrative expenses in absolute dollars and as a percentage of revenues during fiscal year 2007 was due to several factors. Professional and legal expenses increased by approximately $8.2 million, primarily related to settlement costs of several lawsuits and defense of patent litigation during fiscal year 2007. Employee-related expenses increased approximately $1.8 million as a result of an increase in our headcount of approximately 10 additional employees hired to support our infrastructure. Allocated information technology costs also increased approximately $0.8 million as a result of our increased headcount. These increases were partially offset by a decrease in the charge for our allowance for doubtful accounts by $1.2 million as a result of overall improvements in our accounts receivables. Stock-based compensation expense increased $6.1 million during fiscal year 2007 as a result of the adoption of SFAS No. 123(R).

 

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Amortization of Intangible Assets

 

     Years Ended May 31,     Increase/
(Decrease)
 
     2007    % of Revenue     2006    % of Revenue    
     (dollars in thousands)  

Amortization of intangible assets

   $ 1,981    0.1 %   $ 4,589    0.3 %   $ (2,608 )

The decrease in amortization of intangible assets in absolute dollars for fiscal year 2007 was primarily due to a $3.2 million decrease in amortization of intangible assets acquired in connection with the Handspring acquisition because these assets became fully amortized during the second quarter of fiscal year 2006. This decrease was partially offset by a $0.6 million increase in amortization resulting from the acquisition of intangible assets during the third quarter of fiscal year 2007.

Restructuring Charges

 

     Years Ended May 31,     Increase/
(Decrease)
 
     2007    % of Revenue     2006    % of Revenue    
     (dollars in thousands)  

Restructuring charges

   $   —      —   %   $ 792    —   %   $ (792 )

Restructuring charges recorded during fiscal year 2006 of $0.8 million consisted of restructuring actions taken during the second quarter of fiscal year 2006 of approximately $2.1 million partially offset by a $1.3 million adjustment to restructuring actions taken in connection with the Handspring acquisition as a result of more current information regarding future estimated sublease income.

The second quarter of fiscal year 2006 restructuring actions consisted of workforce reductions for approximately 20 regular employees, primarily in Europe. Restructuring charges were a result of our effort to focus our international sales force on smartphone products. Cash payments of approximately $2.1 million were made related to these workforce reductions as of May 31, 2006. Cost reduction actions initiated in the second quarter of fiscal year 2006 are complete.

We cannot assure you that our estimates of the costs associated with the restructuring action taken in connection with the Handspring acquisition will not change due to changes in underlying lease and sublease arrangements.

In-process Research and Development

 

     Years Ended May 31,     Increase/
(Decrease)
     2007    % of Revenue     2006    % of Revenue    
     (dollars in thousands)

In-process research and development

   $ 3,700    0.2 %   $   —      —   %   $ 3,700

In-process research and development for fiscal year 2007 in absolute dollars was the result of the acquisition of assets during the third quarter of fiscal year 2007 which represented purchased in-process research and development that had not yet reached technological feasibility, had no alternative future use and was charged to operations.

Legal Settlements

 

     Years Ended May 31,     Increase/
(Decrease)
 
     2007    % of Revenue     2006    % of Revenue    
     (dollars in thousands)  

Legal settlements

   $   —      —   %   $ 23,775    1.5 %   $ (23,775 )

In June 2006, we entered into a legal settlement with Xerox Corporation for $22.5 million, as well as an additional settlement for $1.3 million.

 

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Interest (Expense)

 

     Years Ended May 31,     Increase/
(Decrease)
 
     2007     % of Revenue     2006     % of Revenue    
     (dollars in thousands)  

Interest (expense)

   $ (1,970 )   (0.1 )%   $ (3,134 )   (0.2 )%   $ (1,164 )

The decrease in interest expense during fiscal year 2007 as compared to fiscal year 2006 was primarily due to lower outstanding debt as a result of the repayment of the convertible debt during the third quarter of fiscal year 2007.

Interest Income

 

     Years Ended May 31,     Increase/
(Decrease)
     2007    % of Revenue     2006    % of Revenue    
     (dollars in thousands)

Interest income

   $ 25,958    1.7 %   $ 17,161    1.1 %   $ 8,797

Interest income increased during fiscal year 2007 primarily due to higher average cash, cash equivalent and short-term investment balances and more favorable interest rates as compared to those experienced during fiscal year 2006.

Other Income (Expense), Net

 

     Years Ended May 31,     Increase/
(Decrease)
 
     2007     % of Revenue     2006     % of Revenue    
     (dollars in thousands)  

Other income (expense), net

   $ (1,619 )   (0.1 )%   $ (2,691 )   (0.2 )%   $ (1,072 )

Other income (expense), net for fiscal year 2007 consisted of approximately $1.7 million in bank and other charges, partially offset by a net gain on sales of short-term investments of approximately $0.1 million. Other income (expense), net for fiscal year 2006 consisted of approximately $1.5 million in bank and other charges and approximately $1.2 million in net losses on sales of short-term investments.

Income Tax Provision (Benefit)

 

     Years Ended May 31,     Increase/
(Decrease)
     2007    % of Revenue     2006     % of Revenue    
     (dollars in thousands)

Income tax provision (benefit)

   $ 36,044    2.3 %   $ (219,523 )   (13.9 )%   $ 255,567

The income tax provision for fiscal year 2007 was $36.0 million, which consisted of federal, state and foreign income taxes and represented an effective tax rate of 39%. This rate differed from the U.S. statutory rate due to the lack of tax benefits from foreign losses offset in part by research tax credits.

During the second quarter of fiscal year 2006, we determined, based on current and preceding years’ results of operations and anticipated profit levels in future periods, that it was more likely than not that our domestic deferred tax assets would be realized in the future and, accordingly, that it was appropriate to release the valuation allowance recorded against those deferred tax assets resulting in a tax benefit of $250.3 million.

Although we determined that a valuation allowance was no longer required with respect to our domestic net operating loss carryforwards, deferred expenses and tax credit carryforwards, recovery is dependent on achieving the forecast of future operating income over a protracted period of time. As of May 31, 2007, we required

 

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approximately $807 million in cumulative future operating income to be generated at various times over approximately the next 15-20 years to realize our net deferred tax assets. Based upon our results for fiscal year 2007, it would take us less than 9 years to utilize our current NOL and tax credit carryforwards. During this period our profits have also grown, which, if projected into the future, would result in utilization of current NOL and tax credit carryforwards in an even shorter number of years. We will continue to review our forecast in relation to actual results and expected trends on an ongoing basis. The trends include the expected continued growth of the smartphone market. Failure by us to achieve our future operating income targets or negative changes to expected trends may change the assessment regarding the recoverability of the net deferred tax assets and such change could result in a valuation allowance being recorded against some or all of the deferred tax assets. Any increase in a valuation allowance would result in additional income tax expense and could have a significant impact on our earnings in future periods.

Liquidity and Capital Resources

Cash and cash equivalents as of May 31, 2008 were $176.9 million, compared to $128.1 million as of May 31, 2007, an increase of $48.8 million. We experienced an approximately $17.5 million net decrease in cash flows from operations resulting from our net loss of $105.4 million, which was partially offset by non-cash charges of $39.6 million and changes in assets and liabilities of $48.3 million. Our cash increased due to net sales of short-term investments of $260.8 million, net proceeds from the sale of land of $64.4 million, proceeds received from the sale of restricted investments and non-current auction rate securities totaling $0.6 million and $28.5 million from stock-related activity as a result of the exercise of stock options and other equity awards. Fluctuations in exchange rates during fiscal year 2008 for our foreign currency denominated assets and liabilities resulted in an increase in cash flows of approximately $1.7 million for fiscal year 2008. These increases were partially offset by purchases of property and equipment of $23.0 million, the purchase of restricted investments of $9.0 million, payments for the acquisition of a business of $0.5 million, payments for the acquisition of intangible brand assets of $1.5 million and debt repayments of $3.1 million. Also, during fiscal year 2008 we completed the Recapitalization Transaction with Elevation Partners which resulted in net cash outflows of approximately $252.6 million due to a $948.9 million one-time cash distribution partially funded by $696.3 million received from incurring new debt and the issuance of preferred stock.

We hold a variety of interest bearing auction rate securities, or ARS, that represent investments in pools of assets, including commercial paper, collateralized debt obligations, credit linked notes and credit derivative products. These ARS investments were intended to provide liquidity via an auction process that resets the applicable interest rate at predetermined calendar intervals, allowing investors to either roll over their holdings or gain immediate liquidity by selling such interests at par. The recent uncertainties in the credit markets have affected all of our holdings in ARS investments and, during fiscal year 2008, auctions for our investments in these securities have failed to settle on their respective settlement dates. Consequently, the investments are not currently liquid and we will not be able to access these funds until a future auction of these investments is successful or a buyer is found outside of the auction process. Maturity dates for these ARS investments range from 2017 to 2052. All of the ARS investments were investment grade quality and were in compliance with our investment policy at the time of acquisition. We currently have the ability and intent to hold these ARS investments until a recovery of the auction process or until maturity. During fiscal year 2008, we reclassified the entire ARS investment balance from short-term investments to non-current auction rate securities on our consolidated balance sheet because of our inability to determine when our investments in ARS would settle. We have also modified our current investment strategy and increased our investments in more liquid money market investments and United States Treasury securities.

Historically, the fair value of ARS investments approximated par value due to the frequent resets through the auction process. While we continue to earn interest on our ARS investments at the maximum contractual rate, these investments are not currently trading and therefore do not currently have a readily determinable market value. The estimated fair value of ARS no longer approximates par value.

 

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We have used a discounted cash flow model to determine the estimated fair value of our investment in ARS as of May 31, 2008. The assumptions used in preparing the discounted cash flow model include estimates for interest rates, timing and amount of cash flows and expected holding periods of the ARS. Based on this assessment of fair value, as of May 31, 2008 we determined there was a decline in the fair value of our ARS investments of $44.7 million, of which $12.5 million was deemed temporary and $32.2 million was recognized as a pre-tax other-than-temporary impairment charge.

We review our impairments in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and related guidance issued by the FASB and SEC in order to determine the classification of the impairment as “temporary” or “other-than-temporary”. A temporary impairment charge results in an unrealized loss being recorded in the other comprehensive income (loss) component of stockholders’ equity. Such an unrealized loss does not affect net income (loss) for the applicable accounting period. An other-than-temporary impairment charge is recorded as a realized loss in the consolidated statement of operations and reduces net income (loss) for the applicable accounting period. In evaluating the impairment of any individual ARS, we classified such impairment as temporary or other-than-temporary. The differentiating factors between temporary and other-than-temporary impairment are primarily the length of the time and the extent to which the market value has been less than cost, the financial condition and near-term prospects of the issuer and our intent and ability to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value.

The valuation of our investment portfolio is subject to uncertainties that are difficult to predict. Factors that may impact its valuation include changes to credit ratings of the securities as well as to the underlying assets supporting those securities, rates of default of the underlying assets, underlying collateral value, discount rates, liquidity and ongoing strength and quality of credit markets.

If the current market conditions deteriorate further, or the anticipated recovery in market values does not occur, we may be required to record additional impairment charges in future quarters. We continue to monitor the market for ARS transactions and consider their impact (if any) on the fair value of our investments.

Our short-term investments are intended to establish a high-quality portfolio that preserves principal, meets liquidity needs, avoids inappropriate concentrations and delivers an appropriate yield in relation to our investment guidelines and market conditions. We have decided to modify the current investment strategy by limiting our investments in ARS to our current holdings and increasing our investments in more liquid investments.

We anticipate our balances of cash, cash equivalents and short-term investments of $258.7 million as of May 31, 2008 will satisfy our operational cash flow requirements for at least the next twelve months. Based on our current forecast, we do not anticipate any short-term or long-term cash deficiencies.

Net accounts receivable was $116.4 million as of May 31, 2008, a decrease of $87.9 million, or 43%, from $204.3 million as of May 31, 2007. Days sales outstanding, or DSO, of receivables was 35 days and 46 days at May 31, 2008 and 2007, respectively. The decrease in net accounts receivable and the decrease in DSO are primarily due to the decrease in our revenues during the last three months of fiscal year 2008 as compared to fiscal year 2007 coupled with a higher percentage of those revenues recorded in fiscal year 2007 later in the period as compared to fiscal year 2008. During fiscal year 2008, the cash conversion cycle decreased 1 day to -6 days compared to -5 days as of fiscal year end 2007. The cash conversion cycle is the duration between the purchase of inventories and services and the collection of the cash for the sale of our products and is an annual metric on which we have focused as we continue to try to efficiently manage our assets.

In September 2006, our Board of Directors authorized a stock buyback program to repurchase up to $250.0 million of our common stock. The program allows repurchases of our shares at our discretion, depending on market conditions, share price and other factors.

 

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The stock repurchase program is designed to return value to our stockholders and minimize dilution from stock issuance. The program will be funded using our existing cash balance and future cash flows. The share repurchases will occur through open market purchases, privately negotiated transactions and/or transactions structured through investment banking institutions as permitted by securities laws and other legal requirements.

During fiscal year 2008, we did not repurchase any shares of common stock through open market purchases. During fiscal year 2007, we repurchased 2,154,000 shares of common stock through open market purchases at an average price of $14.37 per share. Total cash consideration for the repurchased stock was $31.0 million during fiscal year 2007. The repurchased shares have been subsequently retired. We currently do not have any plans to repurchase shares under this stock repurchase program during fiscal year 2009.

The following is a summary of the contractual commitments associated with our debt and lease obligations (which include the related interest), as well as our purchase commitments as of May 31, 2008 (in thousands):

 

     Total    Less than 1 Year    1-3 Years    3-5 Years    More than 5 Years

Long-term debt obligations

   $ 398,000    $ 4,000    $ 8,000    $ 8,000    $ 378,000

Interest on long-term debt obligations (1)

     126,139      23,572      46,872      45,468      10,227

Commitment fee on unused portion of Revolver

     670      152      306      212      —  

Operating lease obligations

     35,977      11,491      22,075      2,411      —  

Minimum purchase commitment obligation for licenses due to Microsoft

     15,145      15,145      —        —        —  

Note payable to PalmSource for brand

     7,500      7,500      —        —        —  

System hardware purchase obligation

     3,713      1,857      1,856      —        —  

Software purchase obligation

     1,361      1,089      272      —        —  

Employee incentive compensation

     6,100      2,100      4,000      —        —  

Cash distribution obligation

     743      462      281      —        —  

FIN No. 48 obligations including interest and penalties (2)

     6,127      —        —        —        6,127
                                  

Total contractual obligations

   $ 601,475    $ 67,368    $ 83,662    $ 56,091    $ 394,354
                                  

 

(1)   Interest on long-term debt obligations is estimated using our effective interest rate as of May 31, 2008, or 5.89%, and with the assumption that minimum payments will be made in accordance with the payment schedule outlined in the Credit Agreement.
(2)   As of May 31, 2008, we had $6.1 million of non-current tax liabilities on our consolidated balance sheet for unrecognized tax positions, including approximately $0.8 million of total accrued interest and penalties. We are unable to make a determination as to whether or not recognition of any unrecognized tax benefits will occur within the next 12 months nor can we make an estimate of the range of any potential changes to the unrecognized tax benefits.

In October 2007, we entered into a Credit Agreement to obtain a Term Loan and a Revolver. Borrowings under the Credit Agreement bear interest at our election at 1-, 2-, 3-, or 6- month LIBOR plus 3.50%, or the Alternative Base Rate (higher of Prime Rate and Federal Funds Rate plus 0.50%) plus 2.50%. As of May 31, 2008, the interest rate for the Term Loan was based on 1-month LIBOR plus 3.50%, or 5.89%. The interest rate may vary based on the market rates described above. In addition, we are required to pay a commitment fee of 0.50% per annum on the average daily unutilized portion of the Revolver. The Credit Agreement is secured by all of the capital stock of certain Palm subsidiaries (limited, in the case of foreign subsidiaries, to 65% of the capital stock of such subsidiaries) and substantially all of our present and future assets. Additionally, the Credit Agreement contains certain restrictions on the ability of Palm and its subsidiaries to engage in certain transactions as well as requirements to make certain prepayments of the Term Loan. During fiscal year ended May 31, 2008, we were not required to make any mandatory prepayments on our Term Loan. See Note 11 of the

 

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consolidated financial statements for a full description of the restrictions and requirements under the Credit Agreement. As of May 31, 2008, $398.0 million and $0 were outstanding under the Term Loan and Revolver, respectively.

Palm facilities are leased under operating leases that expire at various dates through May 2012.

In December 2006, we entered into a minimum purchase commitment obligation with Microsoft Licensing, GP over a two-year contract period. Under the terms of the agreement, we agreed to pay a minimum of $35.0 million through November 2008. In September 2007, the agreement was amended to include an additional minimum purchase commitment of $6.7 million. As of May 31, 2008, we had made payments totaling $26.6 million. The remaining amount due under the agreement was $15.1 million as of May 31, 2008.

In May 2005, we acquired PalmSource’s 55 percent share of the Palm Trademark Holding Company, or PTHC, and rights to the brand name Palm. The rights to the brand had been co-owned by the two companies through PTHC since the October 2003 spin-off of PalmSource from Palm. We agreed to pay $30.0 million in five installments due in May 2005, 2006, 2007 and 2008 and November 2008, and granted PalmSource certain rights to Palm trademarks for PalmSource and its licensees for a four-year transition period. The net present value of these payments, $27.2 million, was recorded as an intangible asset and is being amortized over 20 years. The amortization of the discount reported in interest expense for the years ended May 31, 2008 and 2007 was approximately $0.4 million and $0.9 million, respectively. The remaining amount due to PalmSource under this agreement was $7.5 million as of May 31, 2008.

During fiscal year 2008, we entered into an agreement with Cisco Systems, Inc. to purchase system hardware to support our general infrastructure and one year of maintenance for a total of $3.7 million (net present value of $3.5 million). Under the terms of the agreement, we agreed to make quarterly payments from September 2008 through December 2009. The remaining amount due under the agreement was $3.7 million as of May 31, 2008.

During fiscal year 2007, we entered into a license agreement with Oracle Corporation to purchase software and one year of maintenance for a total of $3.3 million (net present value of $2.9 million). Under the terms of the agreement, we agreed to make quarterly payments over a three-year period ending July 2009. As of May 31, 2008, we had made payments totaling $1.9 million under the agreement. The amortization of the discount reported in interest expense for the years ended May 31, 2008 and 2007 was approximately $0.1 million and $0.2 million, respectively. The remaining amount due under the agreement was $1.4 million as of May 31, 2008.

During February and October 2007, we acquired the assets of several businesses. Under the purchase agreements, we agreed to pay up to $8.1 million over four years in employee incentive compensation based upon continued employment with Palm that will be recognized as compensation expense over the service period of the applicable employees. As of May 31, 2008, we had made payments totaling approximately $2.0 million under the purchase agreements. The remaining amount due under these agreements was $6.1 million as of May 31, 2008.

In October 2007, we declared a $9.00 per share one-time cash distribution on all shares outstanding as of October 24, 2007. Of the shares outstanding on this date, approximately 0.1 million were restricted stock awards that had not yet vested. As a result, we recorded a distribution liability of approximately $1.1 million at the end of the second quarter of fiscal year 2008, which will be paid out as the related shares vest, ending in the fourth quarter of fiscal year 2010. As of May 31, 2008, we had a remaining liability of approximately $0.7 million. Approximately $0.4 million of this amount is classified in other accrued liabilities in the consolidated balance sheet and approximately $0.3 million is classified within other non-current liabilities.

As of May 31, 2008, we had $6.1 million of non-current tax liabilities in our consolidated balance sheet for unrecognized tax positions. The periods in which we will reach cash settlement with the respective tax authorities cannot be reasonably estimated.

 

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We accrue for royalty obligations to certain technology and patent holders based on (1) unit shipments of our smartphones and handheld computers, (2) a percentage of applicable revenue for the net sales of products using certain software technologies or (3) 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 $43.7 million as of May 31, 2008, including estimated royalties of $34.5 million 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 May 31, 2008 or on the results reported for the year then ended; however, the effect of finalization of these agreements in the future may be significant to the period in which recorded.

We utilize contract manufacturers to build our products. These contract manufacturers acquire components and build products based on demand forecast information supplied by us, which typically covers a rolling 12-month period. Consistent with industry practice, we acquire inventories from such manufacturers through blanket purchase orders against which orders are applied based on projected demand information. Such purchase commitments typically cover our forecasted product requirements for periods ranging from 30 to 90 days. In certain instances, these agreements allow us the option to cancel, reschedule and/or adjust our requirements based on our business needs. In some instances we also make commitments with component suppliers in order to secure availability of key components that may be in short supply. Consequently, only a portion of our purchase commitments arising from these agreements may be non-cancelable and unconditional commitments. As of May 31, 2008, our cancellable and non-cancellable commitments to third-party manufacturers and suppliers for their inventory on-hand and component commitments related to the manufacture of our products were approximately $234.1 million.

In October 2005, we entered into a three-year, $30.0 million revolving credit line with Comerica Bank. As of May 31, 2007, we had used the revolving credit line with Comerica Bank to support the issuance of letters of credit totaling $9.1 million. During the second quarter of fiscal year 2008, we closed this revolving credit line in conjunction with concluding the Credit Agreement and cash collateralized the outstanding letters of credit. As of May 31, 2008, we had approximately $8.6 million in restricted investments, which are collateral for outstanding letters of credit.

We use foreign exchange forward contracts to mitigate transaction gains and losses generated by certain foreign currency denominated monetary assets and liabilities, the result of which partially offsets our market exposure to fluctuations in foreign currencies. Changes in the fair value of these foreign exchange forward contracts are largely offset by re-measurement of the underlying assets and liabilities. These foreign exchange forward contracts have maturities of 28 days or less. As of May 31, 2008, our outstanding notional contract value, which approximates fair value, was approximately $7.0 million which settled within 28 days. We do not enter into derivatives for speculative or trading purposes.

In October 2007, we sold an aggregate of 325,000 shares of our Series B Preferred Stock for an aggregate purchase price of $325.0 million to Elevation Partners, L.P. For so long as Elevation Partners holds any outstanding shares of Series B Preferred Stock, we are generally not permitted, without obtaining the consent of holders representing at least a majority of the then outstanding shares of Series B Preferred Stock, to create or issue any equity securities that rank senior to or on a parity with the Series B Preferred Stock with respect to dividend rights or rights upon our liquidation. The Series B Preferred Stock reflects a discount of approximately $9.8 million, related to issuance costs, resulting in net cash proceeds of $315.2 million. Of these net cash proceeds, $250.2 million was allocated to Series B Preferred Stock, with the remaining $65.0 million allocated to additional paid-in capital as a result of the beneficial conversion feature. The Series B Preferred Stock is classified as mezzanine equity due to redemption provisions which provide for mandatory redemption in seven years of any outstanding Series B Preferred Stock. The Series B Preferred Stock is being accreted to its liquidation value of $325.0 million using the effective yield method, with such accretion being charged against

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additional paid-in capital over seven years. The accretion of the Series B Preferred Stock will be included in our earnings per share calculation over seven years.

Effects of Recent Accounting Pronouncements

See Note 2 of the consolidated financial statements for a full description of recent accounting pronouncements, including the respective expected dates of adoption and effects on results of operations and financial condition.

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Sensitivity

Investments

We currently maintain an investment portfolio consisting mainly of cash equivalents and short-term investments. These available-for-sale securities are subject to interest rate risk and will fall in value if market interest rates increase. The objectives of our investment activities are to maintain the safety of principal, assure sufficient liquidity and achieve appropriate returns. This is accomplished by investing in marketable investment grade securities and by limiting exposure to any one issuance or issuer. We do not include derivative financial investments in our investment portfolio. Our cash and cash equivalents of approximately $176.9 million and $128.1 million as of May 31, 2008 and 2007, respectively, are primarily money market funds and an immediate and uniform increase in market interest rates of 100 basis points from levels at May 31, 2008 or 2007 would cause an immaterial decline in the fair value of our cash equivalents. As of May 31, 2008 and 2007, we had short-term investments of $81.8 million and $418.6 million, respectively. Our investment portfolio primarily consists of highly liquid investments with original maturities at the date of purchase of greater than three months. These available-for-sale investments include government, domestic and foreign corporate debt securities and are subject to interest rate risk and will decrease in value if market interest rates increase. An immediate and uniform increase in market interest rates of 100 basis points from levels as of May 31, 2008 would cause a decline of less than 2%, or approximately $1.2 million, in the fair market value of our short-term investment portfolio. A similar increase in market interest rates from levels as of May 31, 2007 would have resulted in a decline of less than 2%, or $4.4 million, in the fair market value of our short-term investment portfolio as of May 31, 2007. We would expect our net income (loss) or cash flows to be similarly affected, in absolute dollars, by such a change in market interest rates.

We hold a variety of interest bearing ARS that represent investments in pools of assets, including commercial paper, collateralized debt obligations, credit default linked notes and credit derivative products. These ARS investments were intended to provide liquidity via an auction process that resets the applicable interest rate at predetermined calendar intervals, allowing investors to either roll over their holdings or gain immediate liquidity by selling such interests at par. The recent uncertainties in the credit markets have affected all of our holdings in ARS investments and, during fiscal year 2008, auctions for our investments in these securities have failed to settle on their respective settlement dates. Consequently, the investments are not currently liquid and we will not be able to access these funds until a future auction of these investments is successful or a buyer is found outside of the auction process. Maturity dates for these ARS investments range from 2017 to 2052. During fiscal year 2008 we reclassified our entire balance from short-term investments to non-current auction rate securities on our consolidated balance sheet because of our inability to determine when our investments in ARS would settle. We have also modified our current investment strategy and increased our investments in more liquid money market investments and United States Treasury securities. As of May 31, 2008, we determined that there was a decline in the fair value of our ARS investments of approximately $44.7 million, of which $12.5 million was deemed temporary and $32.2 million was recognized as a pre-tax other-than-temporary impairment charge. An immediate and uniform increase in market interest rates of 100 basis points from levels at May 31, 2008 would cause an additional decline of less than 1%, or less than $0.1 million, in the fair market value of our investments in ARS.

 

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Debt Obligation

We have an outstanding variable rate Term Loan totaling $398.0 million as of May 31, 2008. Pursuant to the terms of the related Credit Agreement, which we entered into during fiscal year 2008, we expect to make interest payments at LIBOR plus 3.50%. We do not currently use derivatives to manage interest rate risk. As of May 31, 2008, our interest rate applicable to borrowings under the Credit Agreement was approximately 5.89%. A hypothetical 100 basis point increase in this rate would have a resulting increase in interest expense of approximately $0.1 million each year for every $10.0 million of outstanding borrowings under the Credit Agreement.

Foreign Currency Exchange Risk

We denominate our sales to certain international customers in the Euro, in Pounds Sterling, in Brazilian Real and in Swiss Francs. Expenses and other transactions are also incurred in a variety of currencies. We hedge certain balance sheet exposures and intercompany balances against future movements in foreign currency exchange rates by using foreign exchange forward contracts. Gains and losses on the contracts are intended to offset foreign exchange gains or losses from the revaluation of assets and liabilities denominated in currencies other than the functional currency of the reporting entity. The net gains and losses from the revaluation of foreign denominated assets and liabilities was a gain (loss) of $(1.1) million, $0.3 million and $0.4 million in fiscal years 2008, 2007 and 2006, respectively, and is included in operating income (loss) in our consolidated statements of operations. Our foreign exchange forward contracts have maturities of 30 days or less. Movements in currency exchange rates could cause variability in our revenues, expenses or interest and other income (expense). Our foreign exchange forward contracts outstanding on May 31, 2008 and 2007 had a notional contract value, which approximates fair value, in U.S. dollars of approximately $7.0 million and $10.0 million, respectively, which settled within 30 days. We do not utilize derivative financial instruments for trading purposes.

Equity Price Risk

As of May 31, 2008 we do not own any material equity investments. Therefore, we do not currently have any material direct equity price risk.

 

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Item 8.    Financial Statements and Supplementary Data

Index to Consolidated Financial Statements and Financial Statement Schedule

 

     Page

Consolidated Financial Statements:

  

Report of Independent Registered Public Accounting Firm

   62

Consolidated Statements of Operations for the Years Ended May 31, 2008, 2007 and 2006

   63

Consolidated Balance Sheets as of May 31, 2008 and 2007

   64

Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the Years Ended May  31, 2008, 2007 and 2006

   65

Consolidated Statements of Cash Flows for the Years Ended May 31, 2008, 2007 and 2006

   66

Notes to Consolidated Financial Statements

   67

Quarterly Results of Operations (Unaudited)

   102

Financial Statement Schedule:

  

Schedule II—Valuation and Qualifying Accounts

   112

All other schedules are omitted, because they are not required, are not applicable, or the information is included in the consolidated financial statements and notes thereto.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

Palm, Inc.

Sunnyvale, California

We have audited the accompanying consolidated balance sheets of Palm, Inc. and subsidiaries (the “Company”) as of May 31, 2008 and 2007, the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended May 31, 2008. Our audits also included the financial statement schedule listed in the Index at Item 15(a)2. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company at May 31, 2008 and 2007, and the results of its operations and its cash flows for each of the three years in the period ended May 31, 2008, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

As discussed in Note 2 to the consolidated financial statements, in fiscal year 2007, the Company changed its method of accounting for stock-based compensation in accordance with guidance provided in Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment. As discussed in Note 16 to the consolidated financial statements, effective June 1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an Interpretation of FASB No. 109.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of May 31, 2008, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July 22, 2008 expressed an unqualified opinion on the Company’s internal control over financial reporting.

/s/    DELOITTE & TOUCHE LLP

San Jose, California

July 22, 2008

 

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Palm, Inc.

Consolidated Statements of Operations

(In thousands, except per share amounts)

 

     Years Ended May 31,  
     2008     2007     2006  

Revenues

   $ 1,318,691     $ 1,560,507     $ 1,578,509  

Cost of revenues(*)

     916,810       985,369       1,057,708  
                        

Gross profit

     401,881       575,138       520,801  

Operating expenses:

      

Sales and marketing(*)

     229,702       248,685       205,794  

Research and development(*)

     202,764       190,952       136,243  

General and administrative(*)

     60,778       59,762       44,297  

Amortization of intangible assets

     3,775       1,981       4,589  

Patent acquisition cost

     5,000       —         —    

Restructuring charges(*)

     30,353       —         792  

Gain on sale of land

     (4,446 )     —         —    

In-process research and development

     —         3,700       —    

Legal settlements

     —         —         23,775  
                        

Total operating expenses

     527,926       505,080       415,490  
                        

Operating income (loss)

     (126,045 )     70,058       105,311  

Impairment of non-current auction rate securities

     (32,175 )     —         —    

Interest (expense)

     (20,397 )     (1,970 )     (3,134 )

Interest income

     21,860       25,958       17,161  

Other income (expense), net

     (1,471 )     (1,619 )     (2,691 )
                        

Income (loss) before income taxes

     (158,228 )     92,427       116,647  

Income tax provision (benefit)

     (52,809 )     36,044       (219,523 )
                        

Net income (loss)

     (105,419 )     56,383       336,170  

Accretion of series B redeemable convertible preferred stock

     5,516       —         —    
                        

Net income (loss) applicable to common shareholders

   $ (110,935 )   $ 56,383     $ 336,170  
                        

Net income (loss) per common share:

      

Basic

   $ (1.05 )   $ 0.55     $ 3.33  
                        

Diluted

   $ (1.05 )   $ 0.54     $ 3.19  
                        

Shares used to compute net income (loss) per common share:

      

Basic

     105,891       102,757       100,818  
                        

Diluted

     105,891       104,442       105,745  
                        

(*)    Costs and expenses include stock-based compensation as follows:

      

Cost of revenues

   $ 1,716     $ 2,276     $ 13  

Sales and marketing

     6,607       6,012       656  

Research and development

     10,267       9,024       284  

General and administrative

     12,500       6,943       816  

Restructuring charges

     1,091       —         —    
                        
   $ 32,181     $ 24,255     $ 1,769  
                        

See notes to consolidated financial statements.

 

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Palm, Inc.

Consolidated Balance Sheets

(In thousands, except par value amounts)

 

     May 31,
2008
    May 31,
2007
 
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 176,918     $ 128,130  

Short-term investments

     81,830       418,555  

Accounts receivable, net of allowance for doubtful accounts of $1,169 and $3,172, respectively

     116,430       204,335  

Inventories

     67,461       39,168  

Deferred income taxes

     82,011       135,906  

Investment for committed tenant improvements

     —         1,331  

Prepaids and other

     15,436       10,222  
                

Total current assets

     540,086       937,647  

Restricted investments

     8,620       —    

Non-current auction rate securities

     29,944       —    

Land held for sale

     —         60,000  

Property and equipment, net

     39,636       36,634  

Goodwill

     166,332       167,596  

Intangible assets, net

     61,048       76,058  

Deferred income taxes

     318,850       267,348  

Other assets

     15,746       2,719  
                

Total assets

   $ 1,180,262     $ 1,548,002  
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

    

Accounts payable

   $ 161,642     $ 196,155  

Income taxes payable

     1,088       62,006  

Accrued restructuring

     8,058       5,406  

Provision for committed tenant improvements

     —         1,331  

Current portion of long-term debt

     4,000       —    

Other accrued liabilities

     236,558       216,125  
                

Total current liabilities

     411,346       481,023  

Non-current liabilities:

    

Long-term debt

     394,000       —    

Non-current tax liabilities

     6,127       —    

Other non-current liabilities

     2,098       4,568  

Series B redeemable convertible preferred stock, $0.001 par value, 325 shares authorized; outstanding: 325 shares and 0 shares, respectively; aggregate liquidation value: $325,000 and $0, respectively

     255,671       —    

Stockholders’ equity:

    

Series A preferred stock, $0.001 par value, 125,000 shares authorized; none outstanding

     —         —    

Common stock, $0.001 par value, 2,000,000 shares authorized; outstanding: 108,369 shares and 103,796 shares, respectively

     108       104  

Additional paid-in capital

     659,141       1,492,362  

Accumulated deficit

     (537,484 )     (431,698 )

Accumulated other comprehensive income (loss)

     (10,745 )     1,643  
                

Total stockholders’ equity

     111,020       1,062,411  
                

Total liabilities and stockholders’ equity

   $ 1,180,262     $ 1,548,002  
                

See notes to consolidated financial statements.

 

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Palm, Inc.

Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss)

(In thousands)

 

    Common
Stock
    Additional
Paid-In
Capital
    Unamortized
Deferred
Stock-Based
Compensation
    Accumulated
Deficit
    Accumulated
Other
Comprehensive
Income (Loss)
    Total  

Balances, May 31, 2005

  $ 99     $ 1,406,885     $ (2,422 )   $ (824,251 )   $ 712     $ 581,023  

Components of comprehensive income:

           

Net income

    —         —         —         336,170       —         336,170  

Net unrealized loss on available-for- sale investments

    —         —         —         —         (2,678 )     (2,678 )

Recognized losses included in earnings

    —         —         —         —         1,190       1,190  

Accumulated translation adjustments

    —         —         —         —         92       92  
                 

Total comprehensive income

    —         —         —         —         —         334,774  
                 

Common stock issued under stock plans, net

    4       40,448       (1,894 )     —         —         38,558  

Stock-based compensation expense

    —         337       1,564       —         —         1,901  

Tax benefit from employee stock options

    —         27,649       —         —         —         27,649  
                                               

Balances, May 31, 2006

    103       1,475,319       (2,752 )     (488,081 )     (684 )     983,905  

Components of comprehensive income:

           

Net income

    —         —         —         56,383       —         56,383  

Net unrealized gains on available-for- sale investments

    —         —         —         —         1,522       1,522  

Recognized gains included in earnings

    —         —         —         —         (110 )     (110 )

Accumulated translation adjustments

    —         —         —         —         915       915  
                 

Total comprehensive income

    —         —         —         —         —         58,710  
                 

Common stock issued under stock plans, net

    3       21,923         —         —         21,926  

Stock-based compensation expense

    —         21,503       2,752       —         —         24,255  

Tax benefit from employee stock options

    —         4,578       —         —         —         4,578  

Shares repurchased and retired

    (2 )     (30,961 )           (30,963 )
                                               

Balances, May 31, 2007

    104       1,492,362       —         (431,698 )     1,643       1,062,411  

Components of comprehensive loss:

           

Net loss

    —         —         —         (105,419 )     —         (105,419 )

Net unrealized losses on available-for- sale investments

    —         —         —         —         (1,261 )     (1,261 )

Net unrealized losses on non-current auction rate securities

    —         —         —         —         (44,706 )     (44,706 )

Net recognized losses on non-current auction rate securities included in earnings

    —         —         —         —         32,175       32,175  

Net recognized gains on available-for-sale investments included in earnings

    —         —         —         —         (68 )     (68 )

Accumulated translation adjustments

    —         —         —         —         1,472       1,472  
                 

Total comprehensive loss

    —         —         —         —         —         (117,807 )
                 

Common stock issued under stock plans, net

    4       28,433         —         —         28,437  

Stock-based compensation expense

    —         32,181       —         —         —         32,181  

Tax benefit from employee stock options

    —         (3,663 )     —         —         —         (3,663 )

Cash distribution to stockholders

    —         (949,691 )     —         —         —         (949,691 )

Discount recognized on issuance of series B redeemable convertible preferred stock

    —         65,035       —         —         —         65,035  

Accretion of series B redeemable convertible preferred stock

    —         (5,516 )     —         —         —         (5,516 )

Adjustment to accumulated deficit due to adoption of FIN No. 48 (see Note 16)

    —         —         —         (367 )     —         (367 )
                                               

Balances, May 31, 2008

  $ 108     $ 659,141     $ —       $ (537,484 )   $ (10,745 )   $ 111,020  
                                               

See notes to consolidated financial statements.

 

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Palm, Inc.

Consolidated Statements of Cash Flows

(In thousands)

 

    Years Ended May 31,  
    2008     2007     2006  

Cash flows from operating activities:

     

Net income (loss)

  $ (105,419 )   $ 56,383     $ 336,170  

Adjustments to reconcile net income (loss) to net cash flows from operating activities:

     

Depreciation

    19,699       13,316       15,112  

Stock-based compensation

    32,181       24,255       1,769  

Amortization of intangible assets

    16,510       8,315       4,589  

Amortization of debt issuance costs

    1,834       —         —    

In-process research and development

    —         3,700       —    

Deferred income taxes

    (58,227 )     11,313       (250,079 )

Realized (gain) loss on equity investments and short-term investments

    (68 )     (110 )     1,190  

Excess tax benefit related to stock-based compensation

    (40 )     (5,241 )     —    

Tax benefit related to stock options

    —         —         11,279  

Realized gain on sale of land

    (4,446 )     —         —    

Impairment of non-current auction rate securities

    32,175       —         —    

Changes in assets and liabilities:

     

Accounts receivable

    89,312       2       (64,175 )

Inventories

    (28,147 )     18,842       (22,466 )

Prepaids and other

    736       1,790       (745 )

Accounts payable

    (35,840 )     11,654       48,781  

Income taxes payable

    3,033       16,421       12,302  

Accrued restructuring

    6,303       (1,803 )     (8,191 )

Other accrued liabilities

    12,866       9,354       52,664  
                       

Net cash provided by (used in) operating activities

    (17,538 )     168,191       138,200  
                       

Cash flows from investing activities:

     

Purchase of brand name intangible asset

    (1,500 )     (44,000 )     —    

Purchase of property and equipment

    (22,999 )     (24,651 )     (18,944 )

Proceeds from sale of land

    64,446       —         —    

Cash paid for business acquisitions

    (495 )     (19,000 )     —    

Purchase of short-term investments

    (517,104 )     (682,882 )     (773,011 )

Purchase of restricted investments

    (8,951 )     —         —    

Sales/maturities of short-term investments

    777,917       671,623       599,719  

Sale of restricted investments

    331       —         775  

Principal received from investment in non-current auction rate securities

    250       —         —    
                       

Net cash provided by (used in) investing activities

    291,895       (98,910 )     (191,461 )
                       

Cash flows from financing activities:

     

Proceeds from issuance of common stock, employee stock plans

    28,437       21,926       38,558  

Purchase and subsequent retirement of common stock

    —         (30,963 )     —    

Proceeds from issuance of series B redeemable convertible preferred stock, net

    315,190       —         —    

Excess tax benefit related to stock-based compensation

    40       5,241       —    

Proceeds from issuance of debt, net

    381,107       —         —    

Repayment of debt

    (3,089 )     (50,816 )     —    

Cash distribution to stockholders

    (948,949 )     —         —    
                       

Net cash provided by (used in) financing activities

    (227,264 )     (54,612 )     38,558  
                       

Effects of exchange rate changes on cash and cash equivalents

    1,695       —         —    

Change in cash and cash equivalents

    48,788       14,669       (14,703 )

Cash and cash equivalents, beginning of period

    128,130       113,461       128,164  
                       

Cash and cash equivalents, end of period

  $ 176,918     $ 128,130     $ 113,461  
                       

Supplemental cash flow information:

     

Cash paid for income taxes

  $ 3,391     $ 8,900     $ 5,878  
                       

Cash paid for interest

  $ 18,042     $ 1,741     $ 1,766  
                       

Non-cash investing and financing activities:

     

Liability for property and equipment acquired

  $ 3,334     $ 2,309     $ —    
                       

See notes to consolidated financial statements.

 

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Palm, Inc.

Notes to Consolidated Financial Statements

Note 1.    Background and Basis of Presentation

Palm, Inc. or Palm or the Company, is a leading provider of mobile products that enhance the lifestyles of individual users and business customers worldwide.

Palm was incorporated in 1992 as Palm Computing, Inc. In 1995, the Company was acquired by U.S. Robotics Corporation. In 1996, the Company sold its first handheld computer, quickly establishing a significant position in the handheld computer industry. In 1997, 3Com Corporation, or 3Com, acquired U.S. Robotics. In 1999, 3Com announced its intent to separate the handheld computer business from 3Com’s business to form an independent, publicly-traded company. In preparation for that spin-off, Palm Computing, Inc. changed its name to Palm, Inc., or Palm, and was reincorporated in Delaware in December 1999. In March 2000, Palm sold shares in an initial public offering and concurrent private placements. In July 2000, 3Com distributed its remaining shares of Palm common stock to 3Com stockholders.

In December 2001, Palm formed PalmSource, Inc., or PalmSource, a stand-alone subsidiary for its operating system, or OS, business. On October 28, 2003, Palm distributed all of the shares of PalmSource common stock held by Palm to Palm stockholders. On October 29, 2003, Palm acquired Handspring, Inc., or Handspring, and changed the Company’s name to palmOne, Inc., or palmOne.

In connection with the spin-off of PalmSource, the Palm Trademark Holding Company, LLC, or PTHC, was formed to hold trade names, trademarks, service marks and domain names containing the word or letter string “palm”. In May 2005, the Company acquired PalmSource’s interest in PTHC, including the Palm trademark and brand, for $30.0 million, payable over 3.5 years. In July 2005, the Company changed its name back to Palm, Inc., or Palm.

In October 2007, the Company sold 325,000 shares of Series B Redeemable Convertible Preferred Stock, or Series B Preferred Stock, to the private-equity firm Elevation Partners, L.P. in exchange for $325.0 million (see Note 13 to the consolidated financial statements). On an as-converted basis, these shares represented approximately 27% of the voting shares outstanding of the Company at the close of the transaction. The Company utilized these proceeds, along with existing cash and the proceeds of $400.0 million of new debt (see Note 11 to the consolidated financial statements), to finance a $9.00 per share one-time cash distribution of approximately $948.9 million to shareholders of record as of October 24, 2007, or the Recapitalization Transaction. Upon closing the Recapitalization Transaction, Elevation Partners has the right to elect two members to Palm’s Board of Directors (see Note 13 to the consolidated financial statements) and Palm adjusted outstanding equity awards in a manner designed to preserve the pre-distribution intrinsic value of the awards (see Note 15 to the consolidated financial statements).

Note 2.    Significant Accounting Policies

Fiscal Year

Palm’s 52-53 week fiscal year ends on the Friday nearest to May 31, 2008. Fiscal years 2008, 2007 and 2006 each contained 52 weeks. For presentation purposes, the periods have been presented as ending on May 31.

Use of Estimates in the Preparation of Consolidated Financial Statements

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 consolidated financial statements and accompanying notes. Palm bases its estimates and judgments on historical experience and on various other assumptions that it believes 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

 

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Palm’s balance sheets and the amounts of revenues and expenses reported for each of Palm’s 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, impairment of non-current auction rate securities, royalty obligations, goodwill and intangible asset valuations, restructurings, inventory, stock-based compensation and income taxes. Actual results could differ from these estimates.

Principles of Consolidation

The consolidated financial statements include the accounts of Palm and its subsidiaries. All significant intercompany balances and transactions are eliminated in consolidation.

Reclassifications

The prior year balances for interest (expense), interest income and other income (expense), net have been reported as separate line items, rather than a combined total, to conform to the current year presentation. This change in presentation had no impact on previously reported results.

Cash Equivalents, Short-Term Investments and Non-Current Auction Rate Securities

Cash equivalents are highly liquid debt investments acquired with remaining maturities of three months or less. Short-term investments are highly liquid debt investments and United States Treasury securities with original maturities at the date of purchase of greater than three months. Non-current auction rate securities, or ARS, are debt investments with original maturities at the date of purchase greater than three months which are not currently liquid.

Palm accounts for cash equivalents, short-term investments and non-current ARS in accordance with Statement of Financial Accounting Standards, or SFAS, No. 115, Accounting for Certain Investments in Debt and Equity Securities. Palm determined the appropriate classification of all cash equivalents, short-term investments and non-current ARS was “available-for-sale” since the time of purchase through May 31, 2008. As such, as of May 31, 2008 and 2007, all of Palm’s cash equivalents, short-term investments and non-current ARS were reported at fair value.

Palm uses the specific identification method of determining the cost basis in computing realized gains and losses on the sale of its available-for-sale securities. Realized gains and losses are included in other income (expense), net. Premiums and discounts are amortized over the period from acquisition to maturity and are included in other income (expense), net along with interest and dividends.

Allowance for Doubtful Accounts

The allowance for doubtful accounts is based on Palm’s assessment of the collectability of specific customer accounts and an assessment of international, political and economic risk as well as the aging of the accounts receivable.

Concentration of Credit Risk

Financial instruments which potentially subject Palm to credit risk consist of cash, cash equivalents and short-term investments which are invested in highly liquid instruments in accordance with Palm’s investment policy. In addition, Palm is subjected to credit risk through its investments in ARS, which are debt investments with original maturities at the date of purchase greater than three months which are not currently liquid. Palm sells the majority of its products through wireless carriers, distributors, retailers and resellers. Palm generally sells on open account and performs periodic credit evaluations of its customers’ financial condition.

 

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The following individual customers accounted for 10% or more of total revenue for the years ended May 31, 2008, 2007 and 2006:

 

     Years Ended May 31,  
     2008     2007     2006  

Sprint Corporation

   41 %   24 %   14 %

Verizon Wireless

   13 %   18 %   30 %

AT&T, Inc.

   11 %   14 %   11 %

The following individual customers accounted for 10% or more of net accounts receivable as of May 31, 2008 and/or 2007:

 

     May 31,  
     2008     2007  

Sprint Corporation

   33 %   36 %

AT&T, Inc.

   15 %   15 %

Brightstar Corporation

   13 %   7 %

Verizon Wireless

   2 %   12 %

Inventories

Inventory purchases and purchase commitments are based upon forecasts of future demand. Palm values its inventory at the lower of standard cost (which approximates first-in, first-out cost) or market. If Palm believes that demand no longer allows it to sell its inventory above cost, or at all, then Palm writes down that inventory to market or writes off excess inventory levels.

Investments for Committed Tenant Improvements

Investments for committed tenant improvements consisted of money market funds. These investments were carried at cost, which approximated fair value, and were restricted as to withdrawal to satisfy the corresponding obligation, provision for committed tenant improvements. Investments for committed tenant improvements were held in brokerage accounts in Palm’s name.

Land Held for Sale, Property and Equipment

Property and equipment are stated at cost. Costs related to internal use software are capitalized in accordance with American Institute of Certified Public Accountants, or AICPA, Statement of Position, or SOP, No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. Depreciation and amortization are computed over the shorter of the estimated useful lives, lease or license terms on a straight-line basis (generally three to five years). Land held for sale was held at cost reduced by impairment charges recorded in prior years as the result of declines in market value. (See Note 5 to consolidated financial statements.)

Goodwill and Intangible Assets

Palm evaluates the recoverability of goodwill annually during the fourth quarter of the fiscal year, or more frequently if impairment indicators arise, as required under 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 Palm’s single reporting segment. A goodwill impairment loss is recorded for any goodwill that is determined to be impaired. Under SFAS No. 144, Accounting for the Impairment or 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 is recognized for an intangible asset to the extent that the asset’s carrying

 

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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 intangible assets for impairment represent management’s best estimates using appropriate assumptions and projections at the time.

Software Development Costs

Costs for the development of new software and substantial enhancements to existing software are expensed as incurred until technological feasibility has been established, at which time any additional development costs would be capitalized. Palm believes its current process for developing software is essentially completed concurrent with the establishment of technological feasibility; accordingly, no costs have been capitalized to date.

Equity Investments

Investments in equity securities with readily available fair values are considered available-for-sale and recorded at fair value with subsequent unrealized gains or losses included as a component of other comprehensive income (loss). Investments in equity securities whose fair values are not readily available and for which Palm does not have the ability to exercise significant influence over the investee’s operating and financial policies are recorded in other assets at fair value, which is the current adjusted cost basis, or $1.0 million as of May 31, 2008 and 2007. Palm evaluates its investments in equity securities on a regular basis and records an impairment charge to other income (expense), net when the decline in the fair value below the cost basis is judged to be other-than-temporary.

Revenue Recognition

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 SOP No. 97-2, Software Revenue Recognition, as amended. Palm recognizes revenues from sales of mobile products 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. Sales to Palm’s customers are subject to agreements allowing for limited rights of return, price protection and rebates. Accordingly, revenue is reduced for Palm’s 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. The reserves for price protection and rebates 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). Price protection is estimated based on specific programs, expected usage and historical experience. Rebates are estimated based on specific programs, actual wireless carrier purchase volumes and the expected percentage of end users that will redeem their rebates, which is estimated based on historical experience. Rebate estimates are refined over the program period as actual results are experienced. Actual claims for returns, price protection and rebates may vary over time and could differ from management’s estimates.

Revenue from software arrangements with end users of Palm’s 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, Palm allocates 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. Palm defers the portion of the arrangement fee equal to the fair value of the undelivered elements until they are delivered.

 

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Royalty Obligations

Palm accrues for royalty obligations to certain technology and patent holders based on (1) unit shipments of its smartphones and handheld computers, (2) a percentage of applicable revenue for the net sales of products using certain software technologies or (3) 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.

Advertising

Advertising costs are expensed as incurred and were $113.2 million, $116.3 million and $90.1 million for fiscal years 2008, 2007, and 2006, respectively. Included within total advertising costs are marketing development funds paid to wireless carriers and channel customers for which Palm receives identifiable benefits whose fair value can be reasonably estimated and which are expensed in the period the related revenue is recognized.

Warranty Costs

Palm accrues 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 any known warranty issues.

Restructuring Costs

In accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, restructuring costs are recorded as incurred. Restructuring charges for employee workforce reductions are recorded upon employee notification for employees whose required continuing service is 60 days or less, and ratably over the employee’s continuing service period for employees whose required continuing service period is greater than 60 days. In conjunction with the Handspring acquisition, Palm accrued for restructuring costs in accordance with EITF Issue No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination. Prior to calendar year 2003, in accordance with EITF Issue No. 94-3, Liability Recognition for Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring), Palm accrued for restructuring costs when it made a commitment to a firm exit plan that specifically identified all significant actions to be taken. Palm records initial restructuring charges based on assumptions and related estimates it deems appropriate for the economic environment at the time these estimates are made. Palm reassesses restructuring accruals on a quarterly basis to reflect changes in the costs of the restructuring activities, and records new restructuring accruals as liabilities are incurred.

Income Taxes

Income tax expense (benefit) for the years ended May 31, 2008, 2007 and 2006 is based on pre-tax financial accounting income or loss. Deferred tax assets represent temporary differences that will result in deductible amounts in future years, including net operating loss carryforwards, deferred expenses and tax credit carryforwards. A valuation allowance reduces deferred tax assets to estimated realizable value, based on estimates, non-expiring credits and certain tax planning strategies. The carrying value of Palm’s net deferred tax assets assumes that it is more likely than not that Palm will be able to generate sufficient future taxable income in certain tax jurisdictions to realize the net carrying value.

Palm does not provide U.S. income taxes on undistributed earnings of its foreign subsidiaries that it expects to permanently reinvest in operations outside the U.S.

Palm accounts for uncertain tax positions in accordance with Financial Accounting Standards Board, or FASB, Financial Interpretation, or FIN, No. 48, Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109. Accordingly, Palm reports a liability for unrecognized tax benefits

 

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resulting from uncertain tax positions taken or expected to be taken in a tax return. Palm recognizes interest and penalties, if any, related to income tax benefits in income tax expense.

Foreign Currency Translation

For non-U.S. subsidiaries with their local currency as their functional currency, assets and liabilities are translated to U.S. dollars, monthly, at exchange rates as of the balance sheet date, and revenues, expenses, gains and losses are translated, monthly, at average exchange rates during the period. Resulting foreign currency translation adjustments are included as a component of other comprehensive income (loss). The net gains and losses from the revaluation of foreign denominated assets and liabilities was a gain (loss) of approximately $(1.1) million, $0.3 million and $0.4 million in fiscal years 2008, 2007 and 2006, respectively, and are included in operating income (loss) in Palm’s consolidated statements of operations.

For Palm entities with the U.S. dollar as the functional currency, foreign currency denominated assets and liabilities are translated to U.S. dollars at the year-end exchange rates except for inventories, prepaid expenses and property and equipment, which are translated at historical exchange rates. Fluctuations in exchange rates during fiscal year 2008 for Palm’s foreign currency denominated assets and liabilities resulted in an increase in cash flows of approximately $1.7 million for fiscal year 2008. Prior year amounts were not significant.

Derivative Instruments

Palm conducts business on a global basis in several currencies. As such, Palm is exposed to movements in foreign currency exchange rates. Palm uses foreign exchange forward contracts to mitigate transaction gains and losses generated by certain foreign currency denominated monetary assets and liabilities, the result of which partially offsets its market exposure to fluctuations in foreign currencies. Changes in the fair value of these foreign exchange forward contracts are largely offset by re-measurement of the underlying assets and liabilities. These foreign exchange forward contracts have maturities of 30 days or less. Palm did not enter into derivatives for speculative or trading purposes or to hedge expected future cash flows during the years ended May 31, 2008, 2007 and 2006.

Stock-Based Compensation

Effective June 1, 2006, Palm adopted SFAS No. 123(R), Share-Based Payment. SFAS No. 123(R) requires companies to record compensation expense for share-based awards issued to employees and directors in exchange for services provided. The amount of the compensation expense is based on the estimated fair value of the awards on their grant dates and is recognized over the requisite service period on a straight-line basis. Palm’s share-based awards include stock options, restricted stock awards, performance shares, or restricted stock units, and Palm’s Employee Stock Purchase Plan.

Prior to the adoption of SFAS No. 123(R), Palm applied the intrinsic value method set forth in Accounting Principles Board, or APB, No. 25, Accounting for Stock Issued to Employees, to calculate the compensation expense for share-based awards. Under APB No. 25, when the exercise price of Palm’s employee stock options was equal to the market price of the underlying stock on the date of the grant, no compensation expense was recorded. In addition, Palm applied the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, as if the fair value based method had been applied in measuring compensation expense. For restricted stock awards and restricted stock units, the valuation and calculation of compensation expense under APB No. 25 and SFAS No. 123(R) is the same.

Palm adopted SFAS No. 123(R) using the modified prospective method, which requires the application of the accounting standard to all share-based awards issued on or after June 1, 2006 and to any outstanding share-based awards that were issued but not vested as of June 1, 2006. Accordingly, Palm’s consolidated financial

 

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statements for the year ended May 31, 2006 have not been restated to reflect the impact of SFAS No. 123(R). Compensation expense for all share-based awards granted prior to June 1, 2006 will continue to be recognized using the accelerated expensing method.

Net Income (Loss) Per Share

Palm follows EITF Issue No. 03-6, Participating Securities and the Two-Class Method under FASB Statement 128, which requires earnings available to common shareholders for the period, after deduction of redeemable convertible preferred stock dividends, to be allocated between the common and redeemable convertible preferred shareholders based on their respective rights to receive dividends. Basic and diluted earnings per share is then calculated by dividing income allocable to common shareholders (after the reduction for any undeclared, preferred stock dividends assuming current income for the period had been distributed) by the weighted average number of shares outstanding. EITF Issue No. 03-6 does not require the presentation of basic and diluted earnings per share for securities other than common stock; therefore, the earnings per common share amounts only pertain to Palm’s common stock.

The following table sets forth the computation of basic and diluted net income (loss) per common share for the fiscal years ended May 31, 2008, 2007 and 2006 (in thousands, except per share amounts):

 

     Years Ended May 31,
     2008     2007    2006

Numerator:

       

Net income (loss)

   $ (105,419 )   $ 56,383    $ 336,170

Effect of dilutive securities:

       

Accretion of series B redeemable convertible preferred stock

     5,516       —        —  
                     

Numerator for basic net income (loss) per common share

     (110,935 )     56,383      336,170

Interest expense on convertible debt, net of taxes

     —         —        1,050
                     

Numerator for diluted net income (loss) per common share

   $ (110,935 )   $ 56,383    $ 337,220
                     

Denominator:

       

Shares used to compute basic net income (loss) per common share (weighted average shares outstanding during the period, excluding shares of restricted stock subject to repurchase)

     105,891       102,757      100,818

Effect of dilutive securities:

       

Restricted stock awards subject to repurchase

     —         14      41

Stock options and employee stock purchase plan

     —         1,659      3,802

Restricted stock units

     —         12      —  

Series B redeemable convertible preferred stock

     —         —        —  

Convertible debt

     —         —        1,084
                     

Shares used to compute diluted net income (loss) per common share

     105,891       104,442      105,745
                     

Basic net income (loss) per common share

   $ (1.05 )   $ 0.55    $ 3.33
                     

Diluted net income (loss) per common share

   $ (1.05 )   $ 0.54    $ 3.19
                     

For the year ended May 31, 2008, approximately 18,851,000 weighted average options to purchase Palm common stock and 23,015,000 weighted average shares of the Series B Preferred Stock (calculated using the “if converted” method) were excluded from the computation of diluted net loss per common share because the inclusion of such items would be antidilutive to the loss. Under the “if converted” method, the Series B Preferred Stock is assumed to be converted to shares at a conversion price of $8.50 and accretion related to the Series B Preferred Stock is added back to net income (loss). Weighted average options to purchase Palm common stock of approximately 11,020,000 and 3,502,000 for the fiscal years ended May 31, 2007 and 2006, respectively, were

 

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excluded from the computations of diluted net income per share because these options’ exercise prices were above the average market price during the period and the effect of including such stock options would have been anti-dilutive. Palm accounted for the effect of the convertible debt in the diluted earnings per share calculation using the “if converted” method. Under that method, the convertible debt is assumed to be converted to shares at a conversion price of $32.30, and interest expense, net of taxes, related to the convertible debt is added back to net income. During fiscal year 2007, Palm retired its outstanding convertible debt. For the fiscal year ended May 31, 2007, approximately 1,084,000 shares of convertible debt were excluded from the computation of diluted net income per share because the effect would have been anti-dilutive.

Comprehensive Income (Loss)

Comprehensive income (loss) consists of net income (loss) plus net unrealized gain (loss) on investments, net unrealized loss on non-current ARS, recognized (gains) losses included in earnings, recognized losses on non-current ARS and accumulated foreign currency translation adjustments and is presented in the statement of stockholders’ equity and comprehensive income (loss).

Effects of Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 provides a framework for measuring fair value, clarifies the definition of fair value, and expands disclosures regarding fair value measurements. SFAS No. 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. Palm is required to adopt SFAS No. 157 to account for its financial assets and liabilities for the fiscal year beginning June 1, 2008. Palm is required to adopt SFAS No. 157 to account for certain nonfinancial assets and liabilities for the fiscal year beginning June 1, 2009. Palm is currently evaluating the effect that the adoption of SFAS No. 157 will have on its consolidated financial statements, but does not expect it to have a material impact.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of SFAS No. 115. SFAS No. 159 allows measurement at fair value of eligible financial assets and liabilities that are not otherwise measured at fair value. If the fair value option for an eligible item is elected, unrealized gains and losses for that item must be reported in current earnings at each subsequent reporting date. SFAS No. 159 also establishes presentation and disclosure requirements designed to draw comparison between the different measurement attributes Palm elects for similar types of assets and liabilities. Palm is required to adopt SFAS No. 159 for the fiscal year beginning June 1, 2008. Palm is currently evaluating the effect, if any, that the adoption of SFAS No. 159 will have on its consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141(Revised 2007), Business Combinations. SFAS No. 141(R) establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. SFAS No. 141(R) also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. Palm is required to adopt SFAS No. 141(R) for the fiscal year beginning June 1, 2009. Palm does not expect the adoption of SFAS 141(R) to have an impact on Palm’s historical financial position or results of operations at the time of adoption.

 

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Note 3.    Cash and Available-For-Sale and Restricted Investments and Non-Current Auction Rate Securities

Palm’s cash and available-for-sale and restricted investments and non-current auction rate securities are as follows (in thousands):

 

     May 31, 2008    May 31, 2007
     Cost    Net
Unrealized

Gain/(Loss)
    Carrying
Value
   Cost    Net
Unrealized

Gain/(Loss)
    Carrying
Value

Cash

   $ 60,916    $ —       $ 60,916    $ 65,279    $ —       $ 65,279

Cash equivalents, money market funds

     116,002      —         116,002      62,851      —         62,851
                                           

Total cash and cash equivalents

   $ 176,918    $ —       $ 176,918    $ 128,130    $ —       $ 128,130
                                           

Short-term investments:

               

Corporate notes/bonds

   $ 7,044    $ (1,768 )   $ 5,276    $ 234,875    $ 2     $ 234,877

Federal government obligations

     76,650      (96 )     76,554      127,211      (531 )     126,680

State and local government obligations

     —        —         —        47,200      —         47,200

Foreign corporate notes/bonds

     —        —         —        9,805      (7 )     9,798
                                           

Total short-term investments

   $ 83,694    $ (1,864 )   $ 81,830    $ 419,091    $ (536 )   $ 418,555
                                           

Investment for committed tenant improvements, money market funds

   $ —      $ —       $ —      $ 1,331    $ —       $ 1,331
                                           

Restricted investments:

               

Money market funds

   $ 8,046    $ —       $ 8,046    $ —      $ —       $ —  

Certificates of deposit

     574      —         574      —        —         —  
                                           

Total restricted investments

   $ 8,620    $ —       $ 8,620    $ —      $ —       $ —  
                                           

Non-current auction rate securities, corporate notes/bonds

   $ 42,475    $ (12,531 )   $ 29,944    $ —      $ —       $ —  
                                           

The following table summarizes the cost and carrying value, which approximates fair value, of debt securities classified as short-term investments based on stated maturities as of May 31, 2008 (in thousands):

 

     Cost    Carrying
Value

Short-term investments

     

Due within one year

   $ 5    $ 5

Due within two years

     76,670      76,573

Due within three years

     —        —  

Due after three years

     7,019      5,252
             

Total short-term investments

   $ 83,694    $ 81,830
             

Due to the short-term nature of these investments, the carrying value approximates fair value. The unrealized losses on these investments were primarily due to uncertainties and recent illiquidity in the credit market and are considered to be temporary in nature.

The net unrealized losses for short-term investments for fiscal year 2008 are $1.9 million. The following table summarizes the fair value and gross unrealized losses related to available-for-sale securities classified as

 

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short-term investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, as of May 31, 2008 (in thousands):

 

     Less than 12 Months     12 Months or More     Total  
     Fair Value    Gross
Unrealized
Loss
    Fair Value    Gross
Unrealized
Loss
    Fair Value    Gross
Unrealized
Loss
 

Corporate notes/bonds

   $ 1,370    $ (608 )   $ 3,808    $ (1,160 )   $ 5,178    $ (1,768 )

Federal government obligations

     76,554      (96 )     —        —         76,554      (96 )
                                             
   $ 77,924    $ (704 )   $ 3,808    $ (1,160 )   $ 81,732    $ (1,864 )
                                             

The net unrealized losses above for fiscal year 2007 of $0.5 million are net of unrealized gains of $0.4 million. The following table summarizes the fair value and gross unrealized losses related to available-for-sale securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, as of May 31, 2007 (in thousands):

 

     Less than 12 Months     12 Months or More     Total  
     Fair Value    Gross
Unrealized
Loss
    Fair Value    Gross
Unrealized
Loss
    Fair Value    Gross
Unrealized
Loss
 

Corporate notes/bonds

   $ 36,156    $ (170 )   $ 4,915    $ (42 )   $ 41,071    $ (212 )

Federal government obligations

     67,804      (422 )     34,793      (314 )     102,597      (736 )

Foreign corporate notes/bonds

     1,326      (6 )     526      (12 )     1,852      (18 )
                                             
   $ 105,286    $ (598 )   $ 40,234    $ (368 )   $ 145,520    $ (966 )
                                             

Palm holds a variety of interest bearing ARS that represent investments in pools of assets, including commercial paper, collateralized debt obligations, credit linked notes and credit derivative products. These ARS investments were intended to provide liquidity via an auction process that resets the applicable interest rate at predetermined calendar intervals, allowing investors to either roll over their holdings or gain immediate liquidity by selling such interests at par. The recent uncertainties in the credit markets have affected all of Palm’s holdings in ARS investments and, during fiscal year 2008, auctions for Palm’s investments in these securities have failed to settle on their respective settlement dates. Consequently, the investments are not currently liquid and Palm will not be able to access these funds until a future auction of these investments is successful or a buyer is found outside of the auction process. Maturity dates for these ARS investments range from 2017 to 2052. All of the ARS investments were investment grade quality and were in compliance with Palm’s investment policy at the time of acquisition. Palm currently has the ability and intent to hold these ARS investments until a recovery of the auction process or until maturity. During fiscal year 2008, Palm reclassified the entire ARS investment balance from short-term investments to non-current auction rate securities on its consolidated balance sheet because of Palm’s inability to determine when its investments in ARS would settle. Palm has also modified its current investment strategy and increased its investments in more liquid money market investments and United States Treasury securities.

Historically, the fair value of ARS investments approximated par value due to the frequent resets through the auction process. While Palm continues to earn interest on its ARS investments at the maximum contractual rate, these investments are not currently trading and therefore do not currently have a readily determinable market value. The estimated fair value of ARS no longer approximates par value.

Palm has used a discounted cash flow model to determine the estimated fair value of its investment in ARS as of May 31, 2008. The assumptions used in preparing the discounted cash flow model include estimates for interest rates, timing and amount of cash flows and expected holding periods of the ARS. Based on this assessment of fair value, as of May 31, 2008 Palm determined there was a decline in the fair value of its ARS investments of $44.7 million, of which $12.5 million was deemed temporary and $32.2 million was recognized as a pre-tax other-than-temporary impairment charge.

 

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Palm reviews its impairments in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and related guidance issued by the FASB and Securities Exchange Commission, or SEC, in order to determine the classification of the impairment as “temporary” or “other-than-temporary.” A temporary impairment charge results in an unrealized loss being recorded in the other comprehensive income (loss) component of stockholders’ equity. Such an unrealized loss does not affect net income (loss) for the applicable accounting period. An other-than-temporary impairment charge is recorded as a realized loss in the consolidated statement of operations and reduces net income (loss) for the applicable accounting period. The primary differentiating factors considered by Palm to classify its impairments between temporary and other-than-temporary impairment are the length of the time and the extent to which the market value of the investment has been less than cost, the financial condition and near-term prospects of the issuer and the intent and ability of Palm to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value.

Note 4.    Inventories

Inventories consist of the following (in thousands):

 

     May 31,
     2008    2007

Finished goods

   $ 65,263    $ 37,736

Work in process and raw materials

     2,198      1,432
             
   $ 67,461    $ 39,168
             

Note 5.    Land Held for Sale

In August 2005, Palm entered into an agreement with a real-estate broker to market for sale the 39 acres of land owned by Palm in San Jose, California. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, Palm reclassified the land as land held for sale at that time. The sale closed in June 2007, and during the first quarter of fiscal year 2008 Palm received proceeds from the sale of land of approximately $64.5 million and recognized a gain on the sale, net of closing costs, of approximately $4.4 million.

Note 6.    Property and Equipment, net

Property and equipment, net, consist of the following (in thousands):

 

     May 31,  
     2008     2007  

Equipment and internal use software

   $ 107,342     $ 99,208  

Leasehold improvements

     17,495       17,708  

Furniture and fixtures

     1,381       1,404  
                

Total

     126,218       118,320  

Accumulated depreciation and amortization

     (86,582 )     (81,686 )
                
   $ 39,636     $ 36,634  
                

Note 7.    Business Combinations

During October 2007, Palm acquired substantially all of the assets of a corporation focused on developing solutions to enhance the performance of web applications. Palm acquired these assets in an all-cash transaction and agreed to the purchase price based on arm’s length negotiations. Palm expects this acquisition to accelerate

 

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the development of future products. The purchase price of approximately $0.5 million was comprised of approximately $0.5 million in cash, of which $0.1 million was deposited with an escrow agent pursuant to the terms of the escrow agreement, and less than $0.1 million in direct transaction costs. This acquisition was accounted for as a purchase in accordance with SFAS No. 141, Business Combinations, or SFAS No. 141. Palm has performed a valuation and determined that the respective fair value of the assets acquired, using a discounted cash flow approach, was de minimus. As a result, goodwill, representing the excess of the purchase price over the fair value of the net identifiable assets acquired, was approximately $0.5 million and is expected to be fully deductible for tax purposes.

During February 2007, Palm acquired the assets of two sole proprietorships focused on mobile computing and media devices, one a developer of user interface environments and the other a developer of email software applications. Palm acquired these assets in all-cash transactions and agreed to the purchase prices based on arm’s length negotiations. Palm expects these acquisitions to accelerate the development of future products. The purchase prices of $19.2 million in the aggregate were comprised of $19.0 million in cash, of which $2.5 million was deposited with an escrow agent pursuant to the terms of escrow agreements and $0.2 million in direct transaction costs. These acquisitions were each accounted for as a purchase in accordance with SFAS No. 141. Palm performed valuations and allocated the total purchase consideration to the assets and liabilities acquired, including identifiable intangible assets based on their respective fair values on the acquisition dates, generally using a discounted cash flow approach. Palm acquired $14.6 million of intangible assets, consisting of $13.7 million in core technology, $0.5 million in non-compete agreements and $0.4 million in customer relationships to be amortized over a weighted-average period of approximately 79 months. Additionally, approximately $3.7 million of the purchase prices represented in-process research and development that had not yet reached technological feasibility, had no future alternative use and was charged to operations at the time of acquisition. Palm did not acquire any tangible assets or assume any liabilities as a result of the acquisitions. Goodwill, representing the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired, was approximately $0.9 million and is expected to be fully deductible for tax purposes.

The results of operations for these acquisitions have been included in Palm’s results of operations since the acquisition dates. The financial results of these businesses prior to their acquisition are immaterial for purposes of pro forma financial disclosures.

Note 8.    Goodwill

Palm accounts for its goodwill in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. As defined by SFAS No. 142, Palm identified two reporting units and allocated goodwill to each unit. During the fourth quarter of fiscal years 2008 and 2007, Palm completed its annual impairment test, and there was no impairment indicated.

Changes in the carrying amount of goodwill are (in thousands):

 

Balance, May 31, 2006

   $ 166,538  

Acquisition of businesses (see Note 7)

     916  

Goodwill adjustments

     142  
        

Balance, May 31, 2007

     167,596  

Acquisition of business (see Note 7)

     495  

Goodwill adjustments

     (1,759 )
        

Balance, May 31, 2008

   $ 166,332  
        

Goodwill increased during fiscal year 2007 due to the acquisition of the assets of two sole proprietorships resulting in goodwill of approximately $0.9 million and during fiscal year 2008 due to the acquisition of a corporation resulting in goodwill of approximately $0.5 million. In addition, Palm made other adjustments to

 

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goodwill relating to the Handspring acquisition primarily for the recognition of foreign tax loss carryforwards and liabilities of approximately $0.1 million for the year ended May 31, 2007 and approximately $(1.8) million for the year ended May 31, 2008. Palm will continue to adjust goodwill as required for changes in tax associated with the Handspring acquisition.

Note 9.    Intangible Assets

Intangible assets consist of the following (dollars in thousands):

 

          May 31, 2008
     Weighted Average
Amortization Period
(months)
   Gross
Carrying
Amount
   Accumulated
Amortization
    Net

Brand

   238    $ 28,700    $ (4,166 )   $ 24,534

Palm OS Garnet license

   60      44,000      (18,900 )     25,100

Acquisition related (see Note 7):

          

Core technology

   83      13,670      (2,562 )     11,108

Contracts and customer relationships

   12      400      (400 )     —  

Non-compete covenants

   36      520      (214 )     306
                        
      $ 87,290    $ (26,242 )   $ 61,048
                        
          May 31, 2007
     Weighted Average
Amortization Period
(months)
   Gross
Carrying
Amount
   Accumulated
Amortization
    Net

Brand

   240    $ 27,200    $ (2,777 )   $ 24,423

Palm OS Garnet license

   60      44,000      (6,300 )     37,700

Acquisition related (see Note 7):

          

Core technology

   83      13,670      (512 )     13,158

Contracts and customer relationships

   12      400      (100 )     300

Non-compete covenants

   36      520      (43 )     477
                        
      $ 85,790    $ (9,732 )   $ 76,058
                        

Amortization expense related to intangible assets was $16.5 million, $8.3 million and $4.6 million for the years ended May 31, 2008, 2007 and 2006, respectively. Amortization of the Palm OS Garnet license and the applicable portion of core technology are included in cost of revenues.

The following table presents the estimated future amortization of intangible assets (in thousands):

 

Years Ended May 31,

    

2009

   $ 15,034

2010

     9,391

2011

     8,565

2012

     5,961

2013

     3,361

Thereafter

     18,736
      
   $ 61,048
      

In January 2008, Palm signed an agreement with Palm Entertainment, LLC to acquire additional rights for use of the Palm trademark in Palm’s operations. For these rights, Palm paid Palm Entertainment, LLC a total of $1.5 million in the third quarter of fiscal year 2008 and is amortizing the intangible asset over the remaining life of Palm’s existing brand intangible asset, or approximately 17 years.

 

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In December 2006, Palm signed an agreement with ACCESS Systems Americas, Inc. (formerly PalmSource, Inc.), or ACCESS Systems, to license the source code for Palm OS Garnet, the version of the Palm OS used in several Palm smartphone models and all Palm handheld computers. Under the agreement, Palm has a royalty-free perpetual license to use as well as to innovate on the Palm OS Garnet code base. Palm will retain ownership rights in its innovations. The agreement also provides Palm flexibility to use Palm OS Garnet in whole or in part in any Palm product, and together with any other system technologies. In addition, Palm secured an expansion of its existing patent license from ACCESS Systems to cover all current and future Palm products, regardless of the underlying operating system. For all of these rights, Palm paid ACCESS Systems a total of $44.0 million in the third quarter of fiscal year 2007 and is amortizing the intangible asset over five years.

In May 2005, Palm acquired PalmSource’s 55 percent share of the PTHC and rights to the brand name Palm. The rights to the brand had been co-owned by the two companies through PTHC since the October 2003 spin-off of PalmSource from Palm, Inc. The agreement provides for Palm to pay $30.0 million in installments over 3.5 years (net present value of $27.2 million) and grants PalmSource certain rights to Palm trademarks for PalmSource and its licensees for a four-year transition period.

Note 10.    Other Accrued Liabilities

Other accrued liabilities consist of the following (in thousands):

 

     May 31,
     2008    2007

Payroll and related expenses

   $ 20,639    $ 27,877

Rebates

     64,929      44,630

Royalty obligations

     34,546      29,414

Product warranty

     40,185      41,087

Marketing development expenses

     18,134      26,050

Other

     58,125      47,067
             
   $ 236,558    $ 216,125
             

Note 11.    Long-Term Debt

In October 2007, Palm entered into a credit agreement with JPMorgan Chase Bank, N.A. and Morgan Stanley Senior Funding, Inc., or the Credit Agreement, which governs a senior secured term loan in the aggregate principal amount of $400.0 million, or the Term Loan, and a credit facility in the aggregate principal amount of $30.0 million, or the Revolver.

The Term Loan matures in April 2014, and bears interest at Palm’s election at 1-, 2-, 3-, or 6-month LIBOR plus 3.50%, or the Alternative Base Rate (higher of Prime Rate or Federal Funds Effective Rate plus 0.50%) plus 2.50%. As of May 31, 2008, the interest rate was based on 1-month LIBOR plus 3.50%, or 5.89%. The principal is payable at 1% of the original balance per annum for the first five and a half years in equal quarterly installments, beginning on December 31, 2007. The remaining principal amount is payable in quarterly installments during the final year preceding the maturity.

The Revolver matures in October 2012, and bears interest at Palm’s election at 1-, 2-, 3-, or 6-month LIBOR plus 3.50%, or the Alternative Base Rate (higher of Prime Rate or Federal Funds Effective Rate plus 0.50%) plus 2.50%. In addition, Palm is required to pay a commitment fee of 0.50% per annum on the average daily unused portion of the Revolver. As of May 31, 2008, Palm has not used the Revolver.

The proceeds received from the Term Loan, net of issuance costs paid, were approximately $381.1 million. Total debt issuance costs of approximately $18.9 million, comprised of underwriting fees, a solvency opinion, credit rating fees and administrative agent fees, have been capitalized and will be amortized to interest expense over the life of the debt. For the fiscal year ended May 31, 2008, total debt issuance costs of approximately $1.8 million were amortized to interest expense.

 

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The Credit Agreement requires Palm to prepay the outstanding balance of the Term Loan using all net cash proceeds Palm receives from the issuance of additional debt or from the disposition of assets outside the ordinary course of business (subject to threshold and reinvestment exceptions). On an annual basis after each fiscal year beginning with fiscal year 2008, Palm is also required to prepay the Term Loan in an amount between 25% and 75% of excess cash flow for the fiscal year, as defined in the Credit Agreement. During fiscal year ended May 31, 2008, Palm was not required to make any mandatory prepayments on its Term Loan. If Palm elects to make additional prepayments of the Term Loan in excess of those required under the Credit Agreement, Palm will be responsible to pay call premiums of (i) 103% in the first year, (ii) 102% in the second year, and (iii) 101% in the third year. Palm is permitted to make voluntary prepayments on the Revolver at any time without premium or penalty.

The Credit Agreement permits Palm to add one or more incremental term loan facilities and/or increase commitments under the Revolver up to $25 million, subject to certain restrictions.

The Term Loan and Revolver contain restrictions on Palm’s and its subsidiaries’ ability to (i) incur certain debt, (ii) make certain investments, (iii) make certain acquisitions of other entities, (iv) incur liens, (v) dispose of assets, (vi) make non-cash distributions to shareholders (except the $9.00 per share distribution described in Note 12 to the consolidated financial statements), and (vii) engage in transactions with affiliates. The Credit Agreement is secured by all of the capital stock of certain Palm subsidiaries (limited, in the case of foreign subsidiaries, to 65% of the capital stock of such subsidiaries) and substantially all of Palm’s present and future assets.

As of May 31, 2008, $398.0 million and $0 were outstanding under the Term Loan and Revolver, respectively. Future loan payments are as follows (in thousands):

 

Years Ended May 31,

    

2009

   $ 4,000

2010

     4,000

2011

     4,000

2012

     4,000

2013

     4,000

Thereafter

     378,000
      
   $ 398,000
      

Note 12.    Commitments

Certain Palm facilities are leased under operating leases. Leases expire at various dates through May 2012.

Future minimum lease payments, including facilities vacated as part of restructuring activities, are as follows (in thousands):

 

Years Ended May 31,

   Operating

2009

   $ 11,491

2010

     11,302

2011

     10,773

2012

     2,411
      
   $ 35,977
      

 

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Rent expense was $10.2 million, $11.0 million and $9.5 million for fiscal years 2008, 2007 and 2006, respectively. In conjunction with its restructuring activities, Palm is subleasing certain excess space, the proceeds from which would partially offset Palm’s future minimum lease commitments. The estimated sublease income is not deducted from the above table of future minimum lease payments. Future minimum lease receivables under subleases are as follows (in thousands):

 

Years Ended May 31,

    

2009

   $ 3,894

2010

     3,936

2011

     3,912

2012

     1,249
      
   $ 12,991
      

Sublease income was approximately $3.8 million, $3.9 million and $3.1 million for fiscal years 2008, 2007 and 2006, respectively. Although Palm has subleased its excess facilities, Palm continues to be the primary obligor for the commitments above.

In December 2006, Palm entered into a minimum purchase commitment obligation with Microsoft Licensing, GP over a two-year contract period. Under the terms of the agreement, Palm agreed to pay a minimum of $35.0 million through November 2008. In September 2007, the agreement was amended to include an additional minimum purchase commitment of $6.7 million. As of May 31, 2008, Palm had made payments totaling $26.6 million. The remaining amount due under the agreement was $15.1 million as of May 31, 2008.

In May 2005, Palm acquired PalmSource’s 55 percent share of PTHC and rights to the brand name Palm. The rights to the brand had been co-owned by the two companies through PTHC since the October 2003 spin-off of PalmSource from Palm. Palm agreed to pay $30.0 million in five installments due in May 2005, 2006, 2007 and 2008 and November 2008, and granted PalmSource certain rights to Palm trademarks for PalmSource and its licensees for a four-year transition period. The net present value of these payments, $27.2 million, was recorded as an intangible asset and is being amortized over 20 years. The amortization of the discount reported in interest expense for the years ended May 31, 2008 and 2007 was approximately $0.4 million and $0.9 million, respectively. The remaining amount due to PalmSource under this agreement was $7.5 million as of May 31, 2008.

During fiscal year 2008, Palm entered into an agreement with Cisco Systems, Inc. to purchase system hardware to support our general infrastructure and one year of maintenance for a total of $3.7 million (net present value of $3.5 million). Under the terms of the agreement, Palm agreed to make quarterly payments from September 2008 through December 2009. The remaining amount due under the agreement was $3.7 million as of May 31, 2008.

During fiscal year 2007, Palm entered into a license agreement with Oracle Corporation to purchase software and one year of maintenance for a total of $3.3 million (net present value of $2.9 million). Under the terms of the agreement, Palm agreed to make quarterly payments over a three-year period ending July 2009. As of May 31, 2008 Palm had made payments totaling $1.9 million under the agreement. The amortization of the discount reported in interest expense for the years ended May 31, 2008 and 2007 was approximately $0.1 million and $0.2 million, respectively. The remaining amount due under the agreement was $1.4 million as of May 31, 2008.

During February and October 2007, Palm acquired the assets of several businesses. Under the purchase agreements, Palm agreed to pay up to $8.1 million over four years in employee incentive compensation based upon continued employment with Palm that will be recognized as compensation expense over the service period of the applicable employees. As of May 31, 2008, Palm had made payments totaling approximately $2.0 million under the purchase agreements. The remaining amount due under these agreements was $6.1 million as of May 31, 2008.

 

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In October 2007, Palm declared a $9.00 per share one-time cash distribution on all shares outstanding as of October 24, 2007, resulting in a cash payout of approximately $948.9 million during fiscal year 2008. Of the shares outstanding on this date, approximately 0.1 million were restricted stock awards that had not yet vested. As a result, Palm recorded a distribution liability of approximately $1.1 million at the end of the second quarter of fiscal year 2008, which will be paid out as the related shares vest, ending in the fourth quarter of fiscal year 2010. As of May 31, 2008, Palm had a remaining liability of approximately $0.7 million. Approximately $0.4 million of this amount is classified in other accrued liabilities in the consolidated balance sheet and approximately $0.3 million is classified within other non-current liabilities.

Palm accrues for royalty obligations to certain technology and patent holders based on (1) unit shipments of its smartphones and handheld computers, (2) a percentage of applicable revenue for the net sales of products using certain software technologies or (3) 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. Palm has accrued royalty obligations of $43.7 million as of May 31, 2008, including estimated royalties of $34.5 million 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 its financial position as of May 31, 2008 or on the results reported for the year then ended; however, the effect of finalization of these agreements in the future may be significant to the period in which recorded.

Palm utilizes contract manufacturers to build its products. These contract manufacturers acquire components and build products based on demand forecast information supplied by Palm, which typically covers a rolling 12-month period. Consistent with industry practice, Palm acquires inventories from such manufacturers through blanket purchase orders against which orders are applied based on projected demand information. Such purchase commitments typically cover Palm’s forecasted product requirements for periods ranging from 30 to 90 days. In certain instances, these agreements allow Palm the option to cancel, reschedule and/or adjust its requirements based on its business needs. In some instances Palm also makes commitments with component suppliers in order to secure availability of key components that may be in short supply. Consequently, only a portion of Palm’s purchase commitments arising from these agreements may be non-cancelable and unconditional commitments. As of May 31, 2008, Palm’s cancellable and non-cancellable commitments to third-party manufacturers and suppliers for their inventory on-hand and component commitments related to the manufacture of Palm products were approximately $234.1 million.

In October 2005, Palm entered into a three-year, $30.0 million revolving credit line with Comerica Bank. As of May 31, 2007, Palm had used the revolving credit line with Comerica Bank to support the issuance of letters of credit totaling $9.1 million. During the second quarter of fiscal year 2008, Palm closed this revolving credit line in conjunction with concluding the new Credit Agreement (see Note 11 to the consolidated financial statements) and cash collateralized the outstanding letters of credit. As of May 31, 2008, Palm had approximately $8.6 million in restricted investments, which are collateral for outstanding letters of credit.

Palm uses foreign exchange forward contracts to mitigate transaction gains and losses generated by certain foreign currency denominated monetary assets and liabilities, the result of which partially offsets its market exposure to fluctuations in foreign currencies. Changes in the fair value of these foreign exchange forward contracts are largely offset by re-measurement of the underlying assets and liabilities. These foreign exchange forward contracts have maturities of 28 days or less. As of May 31, 2008, Palm’s outstanding notional contract value, which approximates fair value, was approximately $7.0 million which settled within 28 days. Palm does not enter into derivatives for speculative or trading purposes.

Under the indemnification provisions of Palm’s customer and certain of its supply agreements, Palm agrees to offer some level of indemnification protection against certain types of claims arising from Palm’s products and services (such as intellectual property infringement or personal injury or property damage caused by Palm’s products or by Palm’s negligence or misconduct).

 

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Under the indemnification provisions with respect to representations and covenants made to PalmSource in connection with the Palm brand and with respect to trademark infringement in the amended and restated trademark license agreement with PalmSource, Palm agreed to defend and indemnify PalmSource and its affiliates for losses incurred, up to $25.0 million under each agreement.

Palm defends and indemnifies its current and former directors and certain of its current and former officers from third-party claims. Certain costs incurred for providing such defense and indemnification may be recoverable under various insurance policies. Palm is unable to reasonably estimate the maximum amount that could be payable under these arrangements since these exposures are not capped and due to the conditional nature of its obligations and the unique facts and circumstances involved in any situation that might arise.

Palm’s product warranty accrual reflects management’s best estimate of probable liability under its product warranties. Management determines the warranty liability based on historical rates of usage as a percentage of shipment levels and the expected repair cost per unit, service policies and its experience with products in production or distribution.

Changes in the product warranty accrual are (in thousands):

 

     Years Ended May 31,  
   2008     2007  

Balance, beginn