Palm fights back (pg. 2)

Elevation did have one modest hit. It consolidated two videogame companies, BioWare and Pandemic Studios, and sold the resulting company in 2007 to gaming giant Electronic Arts (ERTS). Funny thing about that success, though: Co-founder Riccitiello had left Elevation to rejoin EA as chief executive when his company bought BioWare/Pandemic, making him both a buyer and a seller in the transaction. EA disclosed the situation to its shareholders at the time.

Meanwhile, Elevation was busy hatching its plan for Palm. At first it tried to buy Palm outright. Unable to raise enough money, it eventually settled on a minority investment contingent on landing Rubinstein, portrayed by Elevation as the key to remaking Palm. Anderson and McNamee contacted Rubinstein (who had retired) in April 2007, when the former Apple hardware chief's noncompete agreement with Apple expired.

Rubinstein, a rail-thin 52-year-old who commutes by train to Palm's Sunnyvale office from his home in San Francisco, spent his formative years as a computer engineer at Hewlett-Packard and in 1990 joined Next, the company Jobs founded when he was kicked out of Apple. Rubinstein moved to Apple just ahead of Jobs' return and had a key role in the rejuvenation of the Macintosh and the creation of the iPod.

Rubinstein started, in his words, "hanging out" with Palm people in late June. He didn't like what he saw. The hardware for the Pre needed to be scrapped and rebooted. For one thing, prototypes were using old "resistive" touchscreen technology that responds to a user physically pushing the screen, not the newer "capacitive" technology manipulated by the electricity in the user's body. Rubinstein tossed out the old phone's hardware and built a new one in about 15 months. "We were basically running a marathon and doing a heart transplant in the middle of it," says Rubinstein.

While the company was working furiously to ready its new product it had another dilemma: It was running out of money. As the overall market melted down, Palm's shares fell even further, at one point in December nearly touching $1 per share, compared with $5 earlier in the year. Elevation basically doubled down at that point, agreeing just before Christmas to invest another $100 million in Palm. Colligan says the fresh cash was intended to show customers, investors, and - critically - suppliers that Palm had the wherewithal to launch the Pre. They had good reason to doubt it: Palm's finances were increasingly shaky. For the quarter that included Christmas sales, Palm reported a loss of $98 million. The company even seemed plagued by bad luck. It reported a $5 million charge for a "warehouse inventory theft" at a distributor. (Palm says it was insured for the theft.)

All the while, of course, Apple was having a banner year. It was on its way to selling 21 million iPhones. In July it opened the Apple App Store, an online bazaar for applications downloadable to iPhones and iPod Touch devices. Users would soon download a billion programs from the App Store, a new revenue generator for the company that also is making more and more Apple enthusiasts out of non-Mac users.

Finally, though, in early 2009, Palm's luck began to turn. Apple flip-flopped on the health status of Steve Jobs, who then pulled out altogether from the annual Macworld trade show in January and announced a six-month medical leave of absence. With a grim economy, few sexy new products, and an atypically muted Apple, the stage was set at January's Consumer Electronics Show in Las Vegas for Palm to show off its Pre. The product was the surprise hit of the trade show, setting the company's stock price on its gallop northward. Palm took advantage of the run-up to raise another $103 million from public investors. It's in this context that one begins to understand why Apple's Cook was so hot about Palm. The mouse was beginning to roar.

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As Palm readies its launch of the Pre, there's most definitely a glimmer of hope, but the company still faces some tall obstacles. The Pre clearly offers features that neither the iPhone nor RIM's BlackBerry does. Palm, however, wouldn't make a review copy of the phone available to Fortune - typically a sign that not all glitches have been worked out. (In an April earnings call, COO Cook took another swipe at Palm, saying, "It is difficult to comment on products that aren't shipping," leaving him, he said, with nothing intelligent to say about the Pre.)

As for the choice of carriers, it's no surprise that Palm went with Sprint. AT&T (T, Fortune 500) and Verizon (VZ, Fortune 500) each had its megahit product already in the iPhone and the BlackBerry Storm, respectively. What's more, Palm had become increasingly reliant on Sprint. For Palm's year that ended last May, 41% of all its sales, smartphone and otherwise, came from Sprint. With both companies losing money and customers, the pair have increasingly come to look like perennially last-place baseball teams that can't seem to catch a break. Each thinks the new gizmo will change that. "The Palm Pre will be in a category by itself," says Kevin Packingham, a top Sprint executive responsible for devices.

Another knock on Palm is that it's a local player in a global business. Some 80% of its sales are in the U.S., and even assuming the Pre is a success, Palm doesn't currently plan to market it in Asia, where it has no presence.

Then there is the looming battle with Apple. In early March, McNamee caused a stir by telling a wire-service reporter that he thought the Pre was so good that customers would give up their iPhones as soon as their AT&T contracts expired. Palm was forced to file a statement with the SEC calling his comments "premature" and "an exaggerated prediction of consumer behavior." Since then McNamee has toned down his rhetoric - but just a bit. He now calls the relationship with Apple "asymmetric," implying that Palm should have no bearing whatsoever on Apple's plans or performance. Adds Rubinstein: "This is about Palm. It's not about Apple."

Palm and its investors may indeed face a daunting task in launching the Pre and competing with limited resources against the likes of Apple. Yet one thing seems to weigh in Palm's favor: Its confidence and determination don't appear to be in short supply.  

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