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The following is an excerpt from a 10-Q SEC Filing, filed by PALMONE INC on 1/4/2005.
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PALM INC - 10-Q - 20050104 - NOTES_TO_FINANCIAL_STATEMENT

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

1. Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements have been prepared by palmOne, Inc. (formerly Palm, Inc. or Palm), without audit, pursuant to the rules of the Securities and Exchange Commission, or SEC. References to “palmOne,” “the Company,” “we,” “us,” and “our” in this Form 10-Q refer to palmOne, Inc. and its subsidiaries unless the context requires otherwise. In the opinion of management, these unaudited condensed consolidated financial statements include all adjustments necessary for a fair presentation of palmOne’s financial position as of November 30, 2004 and 2003, results of operations for the three and six months ended November 30, 2004 and 2003 and cash flows for the six months ended November 30, 2004 and 2003. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes thereto included in palmOne’s Annual Report on Form 10-K for the fiscal year ended May 31, 2004. The results of operations for the six months ended November 30, 2004 are not necessarily indicative of the operating results for the full fiscal year or any future period.

 

On October 28, 2003, the Company’s stockholders formally approved a plan to spin-off the Company’s operating system, or OS, platform and licensing business through the distribution of all of the shares it owned of its majority-owned subsidiary, PalmSource Inc., or PalmSource, to the stockholders of the Company. The distribution of the shares of PalmSource common stock was intended to be tax-free to palmOne and its stockholders. As a result of the distribution, the Company’s historical condensed consolidated financial statements have been retroactively adjusted to account for PalmSource as discontinued operations for all periods presented in accordance with Statement of Financial Accounting Standards, or SFAS, No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets . Unless otherwise indicated, the Notes to Condensed Consolidated Financial Statements relate to the Company’s continuing operations (See Note 4 to condensed consolidated financial statements). Immediately following the PalmSource distribution, palmOne acquired Handspring, Inc., or Handspring, through a merger transaction between Handspring and a wholly-owned subsidiary of palmOne. Commencing with the date of acquisition, October 29, 2003, the Handspring assets acquired and liabilities assumed, as well as the results of Handspring’s operations are included in our condensed consolidated financial statements. (See Note 9 to condensed consolidated financial statements).

 

palmOne was legally separated from 3Com Corporation, or 3Com, on February 26, 2000 and completed its initial public offering on March 2, 2000. The distribution of palmOne common stock from 3Com to its stockholders was completed on July 27, 2000.

 

palmOne’s 52-53 week fiscal year ends on the Friday nearest to May 31, with each fiscal quarter ending on the Friday generally nearest to August 31, November 30 and February 28. Fiscal year 2005 contains 53 weeks and fiscal year 2004 contains 52 weeks. For presentation purposes, the periods are shown as ending on August 31, November 30, February 28 and May 31, as applicable.

 

2. Stock-Based Compensation

 

palmOne makes awards to its employees under various employee stock plans, which are described more fully in the notes to consolidated financial statements included in palmOne’s Annual Report on Form 10-K for the fiscal year ended May 31, 2004. palmOne accounts for awards under its employee stock plans under the intrinsic value method prescribed by Accounting Principles Board Opinion, or APB, No. 25, Accounting for Stock Issued to Employees , and Financial Accounting Standards Board Interpretation, or FIN, No. 44, Accounting for Certain Transactions Involving Stock Compensation (an Interpretation of APB No. 25) , and has adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-Based Compensation . The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and related guidance.

 

In accordance with APB No. 25, palmOne generally recognizes no compensation expense with respect to shares issued under its employee stock purchase plan and options granted to employees and directors under its stock option plans, collectively referred to as “options.” The Company’s stock option plan also allows for the issuance of restricted stock awards, under which shares of common stock are issued at par value to key employees, subject to certain restrictions, and for which compensation expense equal to the fair market value on the date of the grant is recognized over the vesting period.

 

Pursuant to FIN No. 44, options assumed in a purchase business combination are valued at the date of acquisition at their fair value calculated using the Black-Scholes option valuation model. The fair value of the assumed options is included as part of the purchase price. The intrinsic value attributable to the unvested options is recorded as unearned stock-based compensation and amortized over the remaining vesting period of the related options.

 

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The following table illustrates the effect on net income (loss) and net income (loss) per share if palmOne had elected to recognize stock-based compensation expense based on the fair value of the options granted to employees at the date of grant as prescribed by SFAS No. 123. As a result of the PalmSource distribution, to preserve the intrinsic value of palmOne’s employee stock options, the exercise prices and the number of shares underlying the options outstanding on the date of distribution were adjusted in accordance with the methodology set forth in FIN No. 44. For the purpose of this pro forma disclosure, the estimated fair value of the options is assumed to be amortized to expense over the options’ vesting periods, using the multiple option approach.

 

     Three Months Ended
November 30,


    Six Months Ended
November 30,


 
(In thousands, except per share amounts)    2004(2)

    2003

    2004(2)

    2003

 

Net income (loss), as reported

   $ 24,691     $ (4,118 )   $ 44,285     $ (25,864 )

Add: Stock-based compensation expense included in reported net income (loss), net of related tax effects (1)

     589       1,406       990       2,118  

Less: Stock-based compensation expense determined under fair value method for all awards, net of related tax effects (1)

     (7,197 )     (6,984 )     (12,431 )     (13,829 )
    


 


 


 


Pro forma net income (loss)

   $ 18,083     $ (9,696 )   $ 32,844     $ (37,575 )
    


 


 


 


Net income (loss) per share, as reported:

                                

Basic

   $ 0.51     $ (0.11 )   $ 0.92     $ (0.78 )
    


 


 


 


Diluted

   $ 0.48     $ (0.11 )   $ 0.86     $ (0.78 )
    


 


 


 


Pro forma net income (loss) per share

                                

Basic

   $ 0.37     $ (0.26 )   $ 0.68     $ (1.14 )
    


 


 


 


Diluted

   $ 0.35     $ (0.25 )   $ 0.64     $ (1.14 )
    


 


 


 



(1) Amounts include compensation related to options held by PalmSource employees through the distribution date.
(2) Stock-based compensation expense determined under fair value method for the three and six months ended November 30, 2004 includes amortization related to options cancelled in connection with the option exchange program initiated on March 1, 2004.

 

The fair value of each option grant during the three and six months ended November 30, 2004 and 2003 was estimated at the date of grant using the Black-Scholes option valuation model with the following weighted average assumptions:

 

     Three Months Ended
November 30,


    Six Months Ended
November 30,


 
     2004

    2003

    2004

    2003

 

Assumptions applicable to stock options:

                        

Risk-free interest rate

   2.9 %   1.8 %   2.9 %   1.8 %

Volatility

   75 %   100 %   75 %   100 %

Option term (in years)

   3.11     1.87     3.13     2.46  

Dividend yield

   0.0 %   0.0 %   0.0 %   0.0 %

Assumptions applicable to employee stock purchase plan:

                        

Risk-free interest rate

   1.9 %   2.1 %   1.9 %   2.1 %

Volatility

   98 %   100 %   98 %   100 %

Option term (in years)

   1.99     1.99     1.99     1.99  

Dividend yield

   0.0 %   0.0 %   0.0 %   0.0 %

 

The weighted average estimated fair value of stock options granted were $15.61 per share and $7.04 per share during the three months ended November 30, 2004 and 2003, respectively, and $15.77 per share and $6.92 per share during the six months ended November 30, 2004 and 2003, respectively. The weighted average estimated fair value of shares issued under the employee stock purchase plan were $6.51 per share during the three and six months ended November 30, 2004, and $8.06 per share during the three and six months ended November 30, 2003.

 

On March 1, 2004, palmOne tendered an offer to exchange all unexercised options to purchase shares of palmOne’s common stock that were held by eligible employees, whether vested or unvested, that had exercise prices equal to or greater than $20.00 per share, or the Eligible Options. Eligible employees included all persons who were employees of palmOne or one of its subsidiaries as of March 1, 2004 and who remained employees through the date on which the Eligible Options were cancelled, but did not include members of palmOne’s Board of Directors or palmOne’s Section 16 Officers (which term shall mean any persons who are required to file Forms 3, 4 or 5 with respect to palmOne’s securities under the Securities Exchange Act of 1934, as amended). On March 30, 2004, options to purchase approximately 945,000 shares of palmOne common stock, having a

 

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weighted average exercise price of $164.15 per share, were cancelled. Accordingly and as a result of terminations, the Company granted options to purchase approximately 578,000 shares of palmOne common stock on October 1, 2004 at an exercise price equal to the fair market value at the date of grant, or $32.24, the closing sale price per share of palmOne’s common stock as of November 30, 2004 as reported on the Nasdaq National Market, the majority of which will vest over a 12-month period. Under the provisions of APB No. 25 no compensation expense has been, or will be, recognized in our consolidated statement of operations for the grant of the replacement options.

 

3. Recent Accounting Pronouncements

 

In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment. This statement replaces SFAS No. 123, Accounting for Stock-Based Compensation and supersedes APB No. 25, Accounting for Stock Issued to Employees . SFAS 123(R) requires companies to apply a fair-value-based measurement method in accounting for shared-based payment transactions with employees and to record compensation cost for all stock awards granted after the required effective date and to awards modified, repurchased, or cancelled after that date. In addition, the Company is required to record compensation expense (as previous awards continue to vest) for the unvested portion of previously granted awards that remain outstanding at the date of adoption. SFAS 123(R) will be effective for quarterly periods beginning after June 15, 2005, which is palmOne’s second quarter of fiscal year 2006. Management has not yet determined the impact that SFAS 123(R) will have on its financial position and results of operations.

 

4. Discontinued Operations

 

On October 28, 2003, the Company’s stockholders formally approved a plan that included the PalmSource distribution and the Handspring acquisition. Accordingly, the historical consolidated financial statements of palmOne have been retroactively adjusted to account for PalmSource as discontinued operations for all periods presented in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets . The discontinued operations data reflects the historical assets and liabilities, results of operations and cash flows of PalmSource, the Palm OS platform and licensing business segment of palmOne, as of and during each respective period presented. No gain or loss was recorded as a result of the PalmSource distribution.

 

Loss from discontinued operations for the three and six months ended November 30, 2003 included PalmSource net revenues of $2.3 million and $11.1 million, respectively. Also included in loss from discontinued operations for the three and six months ended November 30, 2003 are allocated corporate expenses and historical consolidated separation costs of $3.3 million and $5.2 million, respectively, that ceased after the PalmSource distribution.

 

5. Net Income (Loss) Per Share

 

Basic net income (loss) from continuing operations, loss from discontinued operations and net income (loss) per share are calculated based on the weighted average shares of common stock outstanding during the period, excluding shares of restricted stock subject to repurchase. Diluted loss from continuing operations, loss from discontinued operations and net loss per share for the six months ended November 30, 2003 are calculated based on the weighted average shares of common stock outstanding excluding shares subject to repurchase, because the effect of restricted stock subject to repurchase and stock options and warrants outstanding, calculated using the treasury stock method, would have been anti-dilutive. For the six months ended November 30, 2003, approximately 1,133,000 common equivalent shares were excluded from the computations of diluted loss from continuing operations, diluted loss from discontinued operations and diluted net loss per share. Diluted income from continuing operations, diluted loss from discontinued operations and diluted net income (loss) per share for the three months ended November 30, 2004 and 2003 and the six months ended November 30, 2004 are calculated based on the weighted average shares of common stock outstanding during the period, plus the dilutive effect of shares of restricted stock subject to repurchase, stock options and warrants outstanding, calculated using the treasury stock method.

 

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6. Comprehensive Income (Loss)

 

The components of comprehensive income (loss) are (in thousands):

 

     Three Months Ended
November 30,


    Six Months Ended
November 30,


 
     2004

    2003

    2004

    2003

 

Net income (loss)

   $ 24,691     $ (4,118 )   $ 44,285     $ (25,864 )

Other comprehensive income (loss):

                                

Unrealized loss on available-for-sale investments

     (516 )     (38 )     (236 )     (35 )

Recognized loss included in earnings

     56       —         165       —    

Accumulated translation adjustments

     639       559       643       204  
    


 


 


 


Total comprehensive income (loss)

   $ 24,870     $ (3,597 )   $ 44,857     $ (25,695 )
    


 


 


 


 

7. Cash and Available-for-Sale and Restricted Investments

 

The Company’s cash and available–for-sale and restricted investments consist of (in thousands):

 

     November 30, 2004

   May 31, 2004

     Adjusted
Cost


   Unrealized
Loss


    Carrying
Value


   Adjusted
Cost


   Unrealized
Loss


    Carrying
Value


Cash

   $ 42,612    $ —       $ 42,612    $ 47,934    $ —       $ 47,934

Cash equivalents:

                                           

Money market funds

     44,309      —         44,309      50,635      —         50,635

Federal government obligations

     16,800      —         16,800      —        —         —  

State and local government obligations

     12,925      —         12,925      12,000      —         12,000

Corporate notes/bonds

     105,500      —         105,500      80,500      —         80,500

Foreign corporate notes/bonds

     14,000      —         14,000      12,000      —         12,000
    

  


 

  

  


 

       193,534      —         193,534      155,135      —         155,135
    

  


 

  

  


 

Total cash and cash equivalents

   $ 236,146    $ —       $ 236,146    $ 203,069    $ —       $ 203,069
    

  


 

  

  


 

Short-term investments:

                                           

Federal government obligations

   $ 55,647    $ (375 )   $ 55,272    $ 30,495    $ (174 )   $ 30,321

Corporate notes/bonds

     20,343      (134 )     20,209      17,908      (105 )     17,803

Foreign corporate notes/bonds

     1,263      (7 )     1,256      1,263      (5 )     1,258
    

  


 

  

  


 

     $ 77,253    $ (516 )   $ 76,737    $ 49,666    $ (284 )   $ 49,382
    

  


 

  

  


 

Equity investments in publicly traded companies

   $ —      $ —       $ —      $ 273    $ (151 )   $ 122
    

  


 

  

  


 

Investment for committed tenant improvements, money market funds

   $ 6,956    $ —       $ 6,956    $ 7,197    $ —       $ 7,197
    

  


 

  

  


 

Restricted investments, certificates of deposit

   $ 775    $ —       $ 775    $ 1,175    $ —       $ 1,175
    

  


 

  

  


 

 

palmOne’s unrealized loss positions are less than twelve months in age.

 

8. Inventories

 

Inventories consist of (in thousands):

 

     November 30,
2004


   May 31,
2004


Finished goods

   $ 25,513    $ 12,219

Work-in-process and raw materials

     3,606      1,811
    

  

     $ 29,119    $ 14,030
    

  

 

9. Business Combinations

 

On October 29, 2003, palmOne acquired Handspring, a leading provider of smartphones and communication devices, exchanging 0.09 of a share of palmOne common stock for each outstanding share of Handspring common stock and assuming outstanding options and warrants to purchase Handspring common stock based on this same exchange ratio. The exchange ratio for the acquisition was determined based on an arm’s length negotiation between palmOne and Handspring. The Handspring acquisition resulted in the issuance of approximately 13.6 million shares of palmOne common stock. The purchase price of $249.9 million is comprised of (a) approximately $209.2 million representing the fair value of palmOne common stock issued to

 

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former Handspring stockholders, (b) $28.0 million representing the estimated fair value of Handspring options and warrants assumed using the Black-Scholes option valuation model, (c) $6.5 million of direct transaction costs and (d) $6.2 million of other liabilities directly related to the acquisition.

 

The $6.2 million of other liabilities directly related to the Handspring acquisition includes $1.8 million related to workforce reductions primarily in the United States, of approximately 50 Handspring employees, $3.7 million related to Handspring facilities not intended for use for palmOne operations and therefore considered excess, and $0.7 million related to other miscellaneous charges incurred as a result of the acquisition which will not benefit palmOne in the future. As of May 31, 2004, the Company adjusted the initial estimate of liabilities directly related to the acquisition as a result of greater costs than originally estimated for employee termination benefits and costs to exit certain facilities. All adjustments were recorded as a net increase in goodwill. As of November 30, 2004, the Company adjusted the estimated costs for employee termination benefits and costs to exit certain facilities. As of November 30, 2004, the workforce reductions were complete.

 

Accrued liabilities recognized in connection with the Handspring acquisition consist of (in thousands):

 

     Initial Liability
Recognized at
October 29,
2003


   Cash
Payments


    Adjustments

   Balance at
May 31,
2004


   Cash
Payments


    Adjustments

    Balance at
November 30,
2004


Workforce reduction costs

   $ 1,805    $ (2,029 )   $ 244    $ 20    $ —       $ (20 )   $ —  

Excess facilities costs

     3,689      (2,065 )     1,913      3,537      (977 )     (137 )     2,423

Other

     660      (673 )     13      —        —         —         —  
    

  


 

  

  


 


 

     $ 6,154    $ (4,767 )   $ 2,170    $ 3,557    $ (977 )   $ (157 )   $ 2,423
    

  


 

  

  


 


 

 

The following unaudited pro forma financial information presents the combined results of operations of palmOne and Handspring as if the Handspring acquisition had occurred as of the beginning of the periods presented. Due to different historical fiscal period ends for palmOne and Handspring, the pro forma results are derived from the same periods for both palmOne and Handspring as follows:

 

palmOne Reporting Period


 

Handspring Period Included in Pro Forma Data


Three months ended November 30, 2004

  *

Three months ended November 30, 2003

  September 1, 2003—October 28, 2003 *

   Six months ended November 30, 2004

  *

   Six months ended November 30, 2003

  June 1, 2003—October 28, 2003 *

* Results from operations of the former Handspring business are included in palmOne results of operations since the date of acquisition (October 29, 2003).

 

This unaudited pro forma financial information includes an adjustment of $1.5 million and $6.8 million for the three and six months ended November 30, 2003, respectively, to the combined results of operations, reflecting amortization of purchased intangible assets and deferred stock based-compensation, that would have been recorded if the acquisition had occurred at the beginning of the periods presented. The unaudited pro forma financial information is not intended to represent or be indicative of the consolidated results of operations or financial condition of palmOne that would have been reported had the acquisition been completed as of the beginning of the periods presented, and should not be taken as representative of the future consolidated results of operations or financial condition of palmOne. Pro forma results for the three and six months ended November 30, 2004 and 2003 were (in thousands, except per share amounts):

 

     Three Months Ended
November 30,


    Six Months Ended
November 30,


 
     2004

   2003

    2004

   2003

 

Pro forma revenues

   $ 376,180    $ 294,640     $ 649,325    $ 475,903  

Pro forma net income (loss)

   $ 24,691    $ (13,329 )   $ 44,285    $ (57,603 )

Pro forma net income (loss) per share:

                              

Basic

   $ 0.51    $ (0.27 )   $ 0.92    $ (1.24 )

Diluted

   $ 0.48    $ (0.27 )   $ 0.86    $ (1.24 )

Shares used in computing per share amounts:

                              

Basic

     48,381      49,973       48,005      46,599  

Diluted

     51,442      49,973       51,223      46,599  

 

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10. Goodwill

 

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

 

     Total

 

Balances, May 31, 2003

   $ 13,815  

Acquisition of Handspring

     241,512  

Goodwill adjustments

     2,036  
    


Balances, May 31, 2004

     257,363  

Goodwill adjustments

     (3,991 )
    


Balances, November 30, 2004

   $ 253,372  
    


 

Goodwill adjustments in fiscal year 2004 of approximately $2.0 million primarily consist of adjustments to the initial estimate of liabilities directly related to the Handspring acquisition as a result of greater costs than originally estimated for employee termination benefits and costs to exit certain facilities. Goodwill adjustments during the six months ended November 30, 2004 of approximately $4.0 million are primarily the result of the release of the valuation allowance on a portion of the deferred tax assets associated with the Handspring acquisition and adjustments to the initial estimate of liabilities directly related to the Handspring acquisition as a result of lower costs than originally estimated for employee termination benefits and costs to exit certain facilities partially offset by the settlement of pre-acquisition litigation and adjustment to our estimated royalty obligations. The Company will continue to adjust goodwill as required for changes in the value of deferred tax assets associated with the Handspring acquisition.

 

11. Intangible Assets

 

Intangible assets consist of (in thousands):

 

     Amortization
Period


   November 30, 2004

   May 31, 2004

      Gross
Carrying
Amount


   Accumulated
Amortization


    Net

   Gross
Carrying
Amount


   Accumulated
Amortization


    Net

Contracts and customer relationships

   24 months    $ 11,900    $ (6,446 )   $ 5,454    $ 11,900    $ (3,471 )   $ 8,429

Customer backlog

   4 months      4,200      (4,200 )     —        4,200      (4,200 )     —  

Product technology

   24 months      1,800      (975 )     825      1,800      (525 )     1,275

Trademarks

   24 months      1,400      (758 )     642      1,400      (408 )     992

Non-compete covenants

   24 months      400      (217 )     183      400      (117 )     283
         

  


 

  

  


 

          $ 19,700    $ (12,596 )   $ 7,104    $ 19,700    $ (8,721 )   $ 10,979
         

  


 

  

  


 

 

Amortization expense related to intangible assets was $1.9 million and $1.7 million for the three months ended November 30, 2004 and 2003, respectively and $3.9 million and $1.7 million for the six months ended November 30, 2004 and 2003, respectively. Estimated future amortization expense for the remaining six months of fiscal year 2005 and for fiscal year 2006 is $3.9 million and $3.2 million, respectively.

 

12. Deferred Income Taxes

 

As of November 30, 2004, palmOne’s deferred tax assets were comprised of net operating loss carryforwards, deferred expenses and tax credit carryforwards of $454.3 million offset by a valuation allowance of $419.5 million. The valuation allowance reduces deferred tax assets to estimated realizable value, based on estimates and certain tax planning strategies. The carrying value of palmOne’s net deferred tax assets assumes that it is more likely than not that palmOne 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 will be 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.

 

The income tax provision for the six months ended November 30, 2004 represented approximately 18% of pretax income, which includes foreign, federal and state income taxes of approximately $4.0 million and acquisition accounting adjustments to goodwill of approximately $5.8 million. The impact of the acquisition accounting adjustments to goodwill in the six months ended November 30, 2004 were partially offset by the favorable conclusion to a tax audit which reduced our first quarter tax provision. The acquisition accounting adjustments to goodwill are related to the recognition of deferred tax assets, including net operating loss carryforwards, related to Handspring that are projected to be realized in the current year to offset taxable income. The tax benefit associated with the utilization of these deferred tax assets is reflected as a goodwill reduction.

 

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13. Commitments and Guarantees

 

palmOne facilities are leased under operating leases that expire at various dates through September 2011.

 

In December 2001, palmOne issued a subordinated convertible note in the principal amount of $50.0 million to Texas Instruments. In connection with the PalmSource distribution on October 28, 2003, the note was canceled and divided into two separate obligations, palmOne retained $35.0 million and the remainder was assumed by PalmSource. The note bears interest at 5.0% per annum, is due in December 2006 and is convertible into palmOne common stock at an effective conversion price of $64.60 per share. palmOne may force a conversion at any time, provided its common stock has traded above $99.48 per share for a defined period of time. In the event palmOne distributes significant assets, palmOne may be required to repay a portion of the note. The note agreement defines certain events of default pursuant to which the full amount of the note plus interest could become due and payable.

 

In connection with the Handspring acquisition, palmOne assumed two notes with remaining principal amounts of $2.5 million and $0.8 million. The notes bear interest at 6% per annum and are payable in equal monthly installments through January 2007. As of November 30, 2004, the remaining principal amounts of the notes are $1.9 million and $0.6 million, respectively.

 

palmOne has a patent and license agreement with a third party vendor under which palmOne is committed to pay $2.7 million in fiscal year 2005.

 

palmOne has an agreement with PalmSource that grants palmOne certain licenses to develop, manufacture, test, maintain and support its products. Under this agreement, palmOne has agreed to pay PalmSource license and royalty fees based upon net revenue of its products which incorporate PalmSource’s software, as well as a source code license and maintenance and support fees. The source code license fee is $6.0 million paid in three equal annual installments in June 2003, June 2004 and June 2005. Annual maintenance and support fees are approximately $0.7 million per year. The agreement includes a minimum annual royalty and license commitment of $39.0 million, $41.0 million and $42.5 million, respectively, during each of the contract years in the period ending December 3, 2006.

 

palmOne utilizes contract manufacturers to build its products. These contract manufacturers acquire components and build product based on demand forecast information supplied by palmOne, which typically covers a rolling 12-month period. Consistent with industry practice, palmOne acquires inventories through a combination of formal purchase orders, supplier contracts and open orders based on projected demand information. Such formal and informal purchase commitments typically cover palmOne’s forecasted component and manufacturing requirements for periods ranging from 30 to 90 days. In certain instances, these agreements allow palmOne the option to cancel, reschedule and adjust its requirements based on its business needs prior to firm orders being placed. Consequently, only a portion of palmOne’s reported purchase commitments arising from these agreements are firm, non-cancelable and unconditional commitments. As of November 30, 2004, palmOne’s commitments to third party manufacturers for inventory on-hand and component purchase commitments related to the manufacture of palmOne products are approximately $139.5 million.

 

In August 2003, palmOne entered into a two-year, $30.0 million revolving credit line with Silicon Valley Bank, or SVB, which was amended and restated to extend the term one more year. The credit line is secured by assets of palmOne, including but not limited to cash and cash equivalents, short-term investments, accounts receivable, inventory and property and equipment. The interest rate is equal to SVB’s prime rate (5.0% at November 30, 2004) or, at palmOne’s election subject to specific requirements, equal to LIBOR plus 1.75% (4.07% at November 30, 2004). The interest rate may vary based on fluctuations in market rates. palmOne is subject to a financial covenant requirement under this agreement to maintain cash on deposit in the United States of not less than $100.0 million. As of November 30, 2004 palmOne had used its credit line to support the issuance of letters of credit of $4.8 million.

 

As part of the agreements with 3Com relating to Palm’s separation from 3Com (palmOne was formerly Palm), palmOne agreed to assume liabilities arising out of the Xerox, E-Pass Technologies, and Connelly litigation matters and to indemnify 3Com for any damages it may incur related to these cases. (See Note 15 to condensed consolidated financial statements.)

 

As part of the agreements with PalmSource relating to the PalmSource distribution, palmOne agreed to assume liabilities arising out of the Xerox litigation and to indemnify PalmSource and PalmSource’s licensees if any claim is brought against any of them alleging infringement of the Xerox patent by covered operating system versions for any damages it may incur related to this case. (See Note 15 to condensed consolidated financial statements.)

 

Under the indemnification provisions of palmOne’s standard reseller agreements and software license agreements, palmOne agrees to defend the reseller/licensee against third party claims asserting infringement by palmOne’s products of certain intellectual property rights, which may include patents, copyrights, trademarks or trade secrets, and to pay any judgments entered on such claims against the reseller/licensee.

 

palmOne’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 specific known issues.

 

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

 

     Six Months Ended
November 30,


 
     2004

    2003

 

Balance, beginning of period

   $ 27,839     $ 17,911  

Payments made

     (28,543 )     (16,109 )

Balance assumed in Handspring acquisition

     —         6,037  

Change in liability for product sold during the period

     26,630       16,887  

Change in liability for pre-existing warranties

     509       (131 )
    


 


Balance, end of period

   $ 26,435     $ 24,595  
    


 


 

14. Restructuring Charges

 

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 period 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.

 

The third quarter of fiscal year 2004 restructuring actions consisted of workforce reductions, in the United States and United Kingdom, of approximately 100 regular employees. Restructuring charges relate to the implementation of actions to streamline the Company consistent with its strategic plan. As of November 30, 2004, 99 regular employees have been terminated as a result of this restructuring. Cost reduction actions initiated in the third quarter of fiscal year 2004 are expected to be substantially complete by the third quarter of fiscal year 2005.

 

The first quarter of fiscal year 2004 restructuring actions consisted of workforce reductions, primarily in the United States, of approximately 45 regular employees, facilities and property and equipment that were disposed of or removed from service and canceled projects. Restructuring charges relate to the implementation of a series of actions to adjust the business consistent with palmOne’s future wireless plans. As of November 30, 2004, all of these headcount reductions have been completed. Cost reduction actions initiated in the first quarter of fiscal year 2004 were substantially completed by the end of fiscal year 2004, except for remaining contractual payments for excess facilities.

 

The third quarter of fiscal year 2003 restructuring actions consisted of workforce reductions, primarily in the United States, of approximately 140 regular employees, facilities and property and equipment disposed of or removed from service and canceled projects. Restructuring charges relate to the implementation of a series of actions to better align the Company’s expense structure with its revenues. As of November 30, 2004, all of these headcount reductions have been completed. Cost reduction actions initiated in the third quarter of fiscal year 2003 are substantially complete except for remaining contractual payments for excess facilities and project termination fees.

 

The fourth quarter of fiscal year 2001 restructuring charges related to carrying and development costs related to the land on which palmOne had previously planned to build its corporate headquarters, facilities costs related to lease commitments for space no longer intended for use, workforce reduction costs across all geographic regions and discontinued project costs. These workforce reductions affected approximately 205 regular employees and were completed during the year ended May 31, 2003. As of November 30, 2004, the balance consists of lease commitments, payable over approximately seven years, offset by estimated sublease proceeds of approximately $21.1 million.

 

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Accrued liabilities related to restructuring actions consist of (in thousands):

 

     Q3 2004
Action


    Q1 2004 Action

    Q3 2003 Action

    Q4 2001
Action


   

Total


 
     Workforce
Reduction
Costs


   

Discontinued
Project

Costs


    Excess
Facilities
and
Equipment
Costs


    Workforce
Reduction
Costs


    Discontinued
Project
Costs


    Excess
Facilities
and
Equipment
Costs


    Workforce
Reduction
Costs


    Excess
Facilities
Costs


   

Balance, May 31, 2003

   $ —       $ —       $ —       $ —       $ 2,367     $ 1,596     $ 1,374     $ 29,549     $ 34,886  

Restructuring expense

     5,172       574       1,515       1,633       —         155       (617 )     —         8,432  

Cash payments

     (4,175 )     (574 )     (687 )     (1,526 )     —         (1,434 )     (757 )     (10,147 )     (19,300 )

Write-offs

     (289 )     —         (23 )     (107 )     —         —         —         —         (419 )
    


 


 


 


 


 


 


 


 


Balance, May 31, 2004

     708       —         805       —         2,367       317       —         19,402       23,599  

Cash payments

     (538 )     —         (342 )     —         —         (239 )     —         (3,949 )     (5,068 )

Write-offs

     —         —         —         —         (45 )     —         —         —         (45 )
    


 


 


 


 


 


 


 


 


Balance, November 30, 2004

   $ 170     $ —       $ 463     $ —       $ 2,322     $ 78     $ —       $ 15,453     $ 18,486  
    


 


 


 


 


 


 


 


 


 

Accrued restructuring as of November 30, 2004 includes accrued liabilities recognized in connection with the Handspring acquisition. (See Note 9 to condensed consolidated financial statements.)

 

15. Litigation

 

palmOne is a party to lawsuits in the normal course of its business. Litigation in general, and intellectual property litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. palmOne believes that it has defenses to each of the cases asserted against it, including the cases set forth below. palmOne is not currently able to estimate, with reasonable certainty, the possible loss, or range of loss, if any, from the cases listed below, and accordingly no provision for any potential loss which may result from the resolution of these matters has been recorded in the accompanying condensed consolidated financial statements except with respect to those cases where preliminary settlement agreements have been reached. An unfavorable resolution of these lawsuits could materially adversely affect palmOne’s business, results of operations or financial condition. (Although Palm, Inc. is now palmOne, Inc. and Handspring has been merged into palmOne, the pleadings in the pending litigation continue to use former company names, including Palm Computing, Inc., Palm, Inc. and Handspring, Inc.)

 

In April 1997, Xerox Corporation filed suit in the United States District Court for the Western District of New York. As a result of subsequent amendments, the case currently names as defendants 3Com Corporation, U.S. Robotics Corporation, U.S. Robotics Access Corp., Palm Computing, Inc., Palm, Inc., PalmSource, Inc., and palmOne Inc. The complaint alleges willful infringement of U.S. Patent No. 5,596,656 (the “‘656 patent”), entitled “Unistrokes for Computerized Interpretation of Handwriting.” The complaint seeks unspecified damages and to permanently enjoin the defendants from infringing the patent in the future. In 2000, the District Court dismissed the case, ruling that the patent is not infringed by the Graffiti handwriting recognition system used in handheld computers using Palm’s operating systems. Xerox appealed the dismissal to the United States Court of Appeals for the Federal Circuit (“CAFC”). On October 5, 2001, the CAFC affirmed-in-part, reversed-in-part and remanded the case to the District Court for further proceedings. On December 20, 2001, the District Court granted Xerox’s motion for summary judgment that the patent is valid, enforceable and infringed. The defendants filed a Notice of Appeal on December 21, 2001. The CAFC remanded the case to the District Court for a determination on the issue of invalidity of the ‘656 patent. On May 21, 2004 the District Court granted palmOne’s motion for summary judgment due to invalidity and denied Xerox’s motion for summary judgment that the patent is not invalid. palmOne filed a Motion for Clarification of the ruling and Xerox filed a Motion for Alteration or Amendment of and Relief from Judgment. Xerox also filed a notice of appeal which has been stayed pending further rulings by the District Court. If palmOne is not successful, palmOne might be liable to PalmSource and/or its licensees if Xerox seeks to enforce its patents claims against PalmSource’s licensees and other third parties. In connection with Palm’s separation from 3Com, palmOne may be required to indemnify and hold 3Com harmless for any damages or losses that may arise out of the Xerox litigation.

 

On February 28, 2000, E-Pass Technologies, Inc. filed suit against 3Com, Inc. in the United States District Court for the Southern District of New York and later filed, on March 6, 2000, an amended complaint against Palm and 3Com. The amended complaint alleges willful infringement of U.S. Patent No. 5,276,311, entitled “Method and Device for Simplifying the Use of Credit Cards, or the Like” and inducement to infringe the same patent. The complaint seeks unspecified compensatory and treble damages and to permanently enjoin the defendants from infringing the patent in the future. The case was transferred to the United States District Court for the Northern District of California. On August 21, 2003, the CAFC issued a ruling reversing summary judgment in favor of Palm and 3Com and remanded the case to the District Court for further proceedings. On February 9, 2004, E-Pass filed another lawsuit in the Northern District of California naming palmOne, Handspring and PalmSource as defendants . This second suit alleges infringement, contributory infringement and inducement of infringement of the same patent,

 

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but identifies additional products as infringing and seeks unspecified compensatory damages, treble damages and a permanent injunction against future infringement. palmOne filed two motions for summary judgment which are pending before the Court. The cases are in the claim construction phase. In connection with Palm’s separation from 3Com, palmOne may be required to indemnify and hold 3Com harmless for any damages or losses that may arise out of the E-Pass litigation.

 

On March 14, 2001, NCR Corporation filed suit against Palm and Handspring, Inc. in the United States District Court for the District of Delaware. The complaint alleges infringement of U.S. Patent Nos. 4,634,845 and 4,689,478, entitled, respectively, “Portable Personal Terminal for Use in a System for Handling Transactions” and “System for Handling Transactions Including a Portable Personal Terminal.” The complaint seeks unspecified compensatory and treble damages and to permanently enjoin the defendants from infringing the patents in the future. On August 28, 2003, the District Court granted both Palm’s and Handspring’s motions for summary judgment, ruling that neither parties’ products infringe the NCR patents, and denied NCR’s motion. NCR appealed the ruling to the Court of Appeals for the Federal Circuit.

 

On January 23, 2003, Peer-to-Peer Systems LLC filed a complaint against Palm in the United States District Court for the District of Delaware. The complaint alleges infringement, contributory infringement, and inducement of infringement of U.S. Patent No. 5,618,045, entitled “Interactive Multiple Player Game System and Method of Playing a Game Between at Least Two Players.” The complaint seeks unspecified compensatory and treble damages and to permanently enjoin the defendant from infringing the patent in the future. In May 2004 the parties reached a tentative settlement that is in the process of being documented and finalized. The terms of the settlement would result in a resolution which is not material to palmOne’s financial position.

 

In June 2001, the first of several putative stockholder class action lawsuits was filed in United States District Court, Southern District of New York against certain of the underwriters for Palm’s initial public offering, Palm and several of its officers. The complaints, which have been consolidated under the caption In re Palm, Inc. Initial Public Offering Securities Litigation , Case No. 01 CV 5613, assert that the prospectus from Palm’s March 2, 2000 initial public offering failed to disclose certain alleged actions by the underwriters for the offering. The complaints allege claims against Palm and the officers under Sections 11 and 15 of the Securities Act of 1933, as amended. Certain of the complaints also allege claims under Section 10(b) and Section 20(a) of the Securities Exchange Act of 1934, as amended. Similar complaints were filed against Handspring in August and September 2001 in regard to Handspring’s June 2000 initial public offering. Other actions have been filed making similar allegations regarding the initial public offerings of more than 300 other companies. An amended consolidated complaint was filed in April 2002. The claims against the individual defendants have been dismissed without prejudice pursuant to an agreement with plaintiffs. The Court denied Palm’s motion to dismiss. Special committees of both Palm’s and Handspring’s respective Boards of Directors approved a tentative settlement proposal from plaintiffs, which includes a guaranteed recovery to be paid by the issuer defendants’ insurance carriers and an assignment of certain claims the issuers, including palmOne and Handspring, may have against the underwriters. There is no guarantee that the settlement will become final, however, as it is subject to a number of conditions, including Court approval. The terms of the settlement would result in a resolution that is not material to palmOne’s financial position.

 

In October 2002, a purported consumer class action lawsuit was filed against Palm in Illinois Circuit Court, Cook County entitled Goldstein v. Palm . The case alleges consumer fraud regarding Palm’s representations that its m100, III, V, and VII handheld personal digital assistant, as sold, would provide wireless access to the Internet and email accounts, and would perform common business functions including data base management, custom form creation and viewing Microsoft Word and Excel documents, among other tasks. The case seeks unspecified actual damages and indemnification of certain costs. Following two successful motions to dismiss filed by Palm, Plaintiff filed a third amended complaint which Palm answered. The case is in the preliminary stages.

 

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During the quarter ended November 30, 2004, the Company reached settlement in connection with the litigation filed by Data Quill Limited against Handspring, and received final court approval of settlements in connection with Connelly v. Palm and 3Com, Hemmingsen v. Palm, and Goldhirsch v. Handspring et. al, and Majarian v. Handspring et al. These matters are described in our Annual Report on Form 10-K for the year ended May 31, 2004. None of the settlements reached in these matters will have a material effect on palmOne’s business or financial statements.

 

16. Related Party Transactions

 

Transactions with 3Com Corporation

 

Subsequent to the date of separation of palmOne from 3Com, palmOne paid 3Com for certain leased facilities through the first quarter of fiscal year 2004 and for transitional services required while palmOne established its independent infrastructure, with transitional services being completed in the third quarter of fiscal year 2002. palmOne’s Chairman of the Board, Eric Benhamou, is also the Chairman of the Board of 3Com.

 

Transactions with PalmSource

 

In December 2001, palmOne entered into a software license agreement with PalmSource which was amended and restated in June 2003. The agreement includes a minimum annual royalty and license commitment of $39.0 million, $41.0 million and $42.5 million, respectively during each of the contract years in the period ending December 3, 2006. Under the software license agreement, palmOne incurred expenses of $14.2 million and $11.8 million during the three months ended November 30, 2004 and 2003, respectively, and $24.5 million and $18.7 million during the six months ended November 30, 2004 and 2003, respectively. palmOne’s Chairman of the Board, Eric Benhamou, was also the Chairman of the Board of PalmSource through October 2004.

 

Other Transactions and Relationships

 

In fiscal year 2003, palmOne made a $1.0 million equity investment in and entered into a product procurement agreement with Mobile Digital Media, Inc. This equity investment is included in other assets. palmOne paid $1.6 million and $3.6 million during the three months ended November 30, 2004 and 2003, respectively, and $3.2 million and $6.2 million during the six months ended November 30, 2004 and 2003, respectively, for products purchased under a product procurement agreement. These products were purchased by palmOne for resale.

 

palmOne purchased software licenses and services from Kontiki, Inc. of $86,000 during each of the three months ended November 30, 2004 and 2003, respectively and $120,000 and $86,000 during the six months ended November 30, 2004 and 2003, respectively. Michael Homer, a current member of palmOne’s Board of Directors, is the Chairman of Kontiki, Inc. Bruce Dunlevie, a current member of palmOne’s Board of Directors, is a partner at Benchmark Capital, which owns more than 10% of the Kontiki stock and has a partner, Kevin Harvey, on the Board of Directors of Kontiki, Inc.

 

palmOne recorded revenues of $0.4 million and $5.3 million during the three months ended November 30, 2004 and 2003, respectively, and $1.1 million and $5.3 million during the six months ended November 30, 2004 and 2003, respectively, from certain subsidiaries of the France Telecom Group. Jean-Jacques Damlamian, a current member of palmOne’s Board of Directors, is the former Senior Vice President, Group Technology and Innovation at France Telecom and is currently a Special Advisor to the Chief Executive Officer of France Telecom. In addition, palmOne recorded expenses of approximately $72,000 and $9,000 during the three months ended November 30, 2004 and 2003, respectively and $523,000 and $20,000 during the six months ended November 30, 2004 and 2003, respectively, primarily for marketing development and mobile telephone services received from subsidiaries of France Telecom Group.

 

palmOne recorded revenues of $11.6 million and $0 during the three months ended November 30, 2004 and 2003, respectively and $27.2 million and $0 during the six months ended November 30, 2004 and 2003 respectively, from T-Mobile USA, Inc. Susan Swenson, a current member of palmOne’s Board of Directors and the chairperson of palmOne’s Audit Committee, became the Chief Operating Officer of T-Mobile USA, Inc. in February 2004.

 

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palmOne paid $0 and $18,000 during the three months ended November 30, 2004 and 2003, respectively and $0 and $36,000 during the six months ended November 30, 2004 and 2003, respectively, to RealNetworks in connection with bundling of products, web site referrals and engineering assistance. Eric Benhamou, Chairman of palmOne’s Board of Directors, is also a member of RealNetworks’ Board of Directors.

 

palmOne is involved in a co-promotional sales and marketing relationship with Good Technology. Good Technology is a value-added reseller of palmOne products. John Doerr, a current member of palmOne’s Board of Directors, serves as a member of Good Technology’s Board of Directors and is a partner at Kleiner Perkins Caufield & Byers, which owns more than 10% of the Good Technology stock. Bruce Dunlevie, a current member of palmOne’s Board of Directors, also serves as a member of Good Technology’s Board of Directors and is a partner at Benchmark Capital, which owns more than 10% of the Good Technology stock.

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