(Business 2.0) – The company that was once synonymous with handheld computing is betting its future on an amicable corporate divorce. This month, Palm plans to split in two--officially separating the team that develops its operating system from the division that manufactures its hardware. PalmSource, the new software company, will set up shop in Sunnyvale, Calif. The hardware unit, tentatively called Palm Solutions, will remain in nearby Milpitas.

Coming on the heels of Palm's planned purchase of Handspring, a rival best known for its stylish smartphones, the breakup is intended to create two more-nimble companies. The entire industry had a dismal 2002, and Palm was no exception. Despite an installed base of 29 million devices, it lost money last year. Yet the market may be poised for a comeback: Research firm IDC predicts that handheld shipments will climb almost 4 percent in 2003.

Palm clearly needed an overhaul. Software licensees had been grumbling about the tension between Palm's need to sell its own hardware and the demands of the clone makers. "It was hard to see the separation between church and state," says Brian Jaquet, a spokesman for Handspring, which will join Palm Solutions in the fall. Other licensees agree. "It's like when Apple licensed its OS in the mid-1990s," says David Yang of Sony, which makes the Palm OS-powered Clie. When competitors undercut Apple's hardware prices, Apple pulled the licenses. That was the danger at Palm.

The hardware unit faces the toughest fight. Last fall, Palm Solutions rolled out the low-cost, consumer-focused Zire and the elegant, enterprise-focused Tungsten. Both have been well received, and Handspring's smartphones will fill a hole in the lineup. But Morningstar analyst Joseph Beaulieu is bearish. He points out that as handhelds become a commodity, consumers will become more price-sensitive, product life cycles will shorten, and competition will continue to grow.

The outlook for PalmSource seems brighter. "With the operating system held by a separate company that lives and dies by licensing it, we can compete more efficiently," claims Palm CFO Judy Bruner. The split may also reassure potential customers, such as Dell, which currently licenses Microsoft's Pocket PC operating system exclusively. "Palm needed this sort of firewall," says Tony Bonadero, director of Dell's handheld division. "Now we wouldn't hesitate to use the Palm OS."

Palm has seen its share of the hardware market erode--from 50 to 32 percent in just three years. Palm's software, which powered two-thirds of all PDAs, now claims just 57 percent. Meanwhile, Microsoft's share of the OS market has risen to 30 percent. As Palm's two divisions part ways, this may well be their last chance to regain momentum. Breaking up is hard to do. But the alternative could be even worse. --MATTHEW MAIER