Palm Inc.'s (PALM) fiscal second-quarter warning late Monday only adds pressure to the highly anticipated next-generation platform slated for the first half of next year.

The Sunnyvale, Calif., company, which pioneered the smartphone market but currently flounders in it, has put all of its eggs into one basket: a Linux- based mobile operating system known as "Nova," designed to rival the latest and greatest from Apple Inc. (AAPL), Research in Motion Ltd. (RIMM) and Google Inc. (GOOG).

But with a product at least two quarters away, Palm needs to hunker down to survive the grueling competition and sharp drop in spending. The company already has vowed to cut expenses by $20 million a quarter. But in slashing its budget, Palm can't ignore its research and development, and must continue to invest even as things get bleak.

"We believe (Palm) needs to balance cost cutting with investment in R&D to ensure a timely launch of new products based on its Linux OS," said T. Michael Walkley, an analyst at Piper Jaffray. "We believe the success of this new OS and products based on it are critical to the viability of Palm longer-term."

Palm hasn't commented specifically on whether it plans to cut R&D. A spokesman wasn't immediately available for comment.

Palm's cost cutswere a reaction to a startling drop in its forecast for fiscal second-quarter revenue, mostly due to a glut of unsold Centros and Treos. Palm expects to post sales of $190 million to $195 million, well below the average analyst estimate of $331 million.

Palm said it would reduce its U.S. work force, consolidate its European operations and shift the responsibility for the Asia-Pacific region to its U.S. offices.

Shares recently fell 18% to $1.54, and the company has lost more than 83% of its market capitalization in the past three months.

Still, Palm's largest backer, Elevation Partners, continues to support the company.

"The company's product pipeline, including a next generation operating system due out soon and a new device targeted for the first half of 2009, excite us enormously," said Roger McNamee, who co-founded the firm. "Elevation supports Palm in taking the difficult but necessary steps required to migrate from legacy products."

McNamee said he has no plans to exit his investment in Palm.

Sticking To The Plan

While marketing and sales will feel the largest brunt of the cost cuts, R&D spending could see a trim, said Matthew Thornton, an analyst at Avian Securities LLC. R&D is the second-largest expense outside of sales, he added.

Cutting resources to R&D, however, would be a mistake. The company can't cut its way out of its situation, and new, strong products are necessary for survival. As Palm has demonstrated over the past few years, innovation has been tough in even the strongest times. Analysts believe Palm staying with its goal of introducing Nova next year is the key to creating sustained momentum.

Keeping the investment flow is a tough decision. Many on Wall Street have expressed concern over the company's cash burn. Palm said it expects to end the fiscal second quarter with $210 million and $220 million. It ended fiscal 2008 with $258 million.

"We continue to believe that a cash infusion may be needed to ensure the company can execute on its turnaround in a challenging market," said Tavis McCourt, an analyst at Morgan Keegan.

Thornton, however, said he believes the company does have enough cash to tide it over until the new product launches, as the company's expense run-rate is around $100 million a quarter.

He noted, however, that a delay in its release could spell trouble for the company. If Palm does need cash, it will likely go to Elevation Partners for additional funds, rather than the capital markets, he said.

McNamee declined to comment on that prospect.

One potential catalyst could be carrier support for the Treo Pro, which launched in August.If the Treo Pro receives a subsidy and marketing support from a carrier, expected early next year, that could provide a stop-gap before the new smartphone arrives. Sprint Nextel Corp. (S) is the likeliest partner, but the carrier declined to comment.

More Challenges

While growth remains in the smartphone business, it is slowing dramatically - a realization hitting the other smartphone makers. Following the Palm news, RIM shares fell 7.6% to $36.76, and Apple shares are off 0.6% to $88.43 - despite a strong day for the overall market.

Apple and RIM may be able to weather the downturn with their strong brands and customer bases, but Palm isn't as fortunate. The Palm name, which once commanded a loyal following, has withered away as users drop its dated operating system.

While making the switch to Windows Mobile for its business-class phones was said to help with enterprise clients, it also affords fewer opportunities to differentiate itself. The Treo Pro, despite stylish changes to its form factor, still offers a similar user experience as other Windows Mobile devices.

Other handset makers such as HTC Corp. (2498.TW), with its Touch Diamond, and Samsung Electronics Co. Ltd. (005930.SE), with its Omnia, use the same underlying mobile operating system but have put their own touches to the interface.

The cuts to its global operations, meanwhile, mean Palm will be more dependent on the U.S. market than ever.

That makes the new platform even more pressing, as it needs a new product to get back on the radar.

"We believe Nova is a compelling software and services platform and is potentially a breakout product in the smartphone space," said Matthew Hoffman, an analyst at Cowen & Co. "However, Palm's operations seem likely to suffer further as shelf space decreases disproportionately versus other smartphone original equipment manufacturers in the near term."

-By Roger Cheng, Dow Jones Newswires; 201-938-2020; roger.cheng@dowjones.com

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12-02-08 1158ET
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