To All: Latest word from Motley Fool on networking sector. If we suppress the emotions we felt re the recent Bay article, his overall point about a new paradigm in valuations for all these companies may have merit given recent business result. Don't flame me; I am just the messenger:
FOOL ON THE HILL
An Investment Opinion by Randy Befumo
Networkers Hit Hard Times
"3Com (Nasdaq:COMS - news) shareholders caught a breather late today when
shares only closed down $1/2 to $32 5/8 after being down as much $2 1/16
this morning. A downpour of earnings estimate revisions followed by the
company's somewhat somber guidance in last night's post-earnings
conference call dragged on the shares. 3Com's plight has tracked almost
exactly that of the industry, as company after company has been laid low
by a lumpy demand, executive error, and management hubris. The
Computer-Local Networks Industry currently ranks 146 out of 197
industries in Investor's Business Daily after sitting at number 16 only
three months ago.
Many investors find it hard to remember a time when companies involved
in the fast-growing networking industry were not doing well, with the
exception of last April. Now it is hard to find a company in the
industry that is doing well. Where small networking companies were once
viewed as an engine of innovation and growth, many of these companies
now have been left behind for dead as the Cisco-led "end-to-end" systems
solutions have come to dominate the industry. The conventional wisdom
holds that if you are not among the top five players, forget about it.
As much as a Fool would like to dispute this conclusion, for the most
part except for companies with expertise in a single product line the
big guys are not involved in, it usually holds true.
While the small companies have been getting smaller, the big have not
been doing all that well either. With the single exception of Cisco
Systems (Nasdaq:CSCO - news) , each of the big five has either warned,
made discouraging comments, or issued questionable and confusing
statements to analysts that some interpreted as negative. In the past
month, 3Com has cleaned out its inventory channel, Cabletron (NYSE:CS -
news) has laid off 600 workers, Bay Networks (NYSE:BAY - news) issued
statements at an analyst meeting interpreted by some attending as
negative, and Ascend Communications (Nasdaq:ASND - news) has only poked
its head up when pretty outlandish rumors of a Lucent (NYSE:LU - news)
buy-out circulated for the umpteenth time.
The problem that many investors have with these companies is that based
on deteriorating financial results, they are not getting cheaper. The
valuations are declining just enough to keep up with the earnings
shortfalls and revenue shortcomings. Take 3Com for instance. In the
quarter it just completed, sales dropped 14% year-over-year and 24%
sequentially to $1.22 billion. The lion's share of this drop came from
the client access business (modems and NICs), which saw revenues tumble
24% year-over-year and 32% sequentially. However, even the systems
business dropped 2% year-over-year and 13% sequentially to $621.5
million. The company reported that it still had inventory to clear in
the systems business next quarter, and that for half a dozen reasons
gross margins might fall further -- indicating that financial results
may not recover substantially until fiscal 1999.
With $621.5 in systems sales, consisting of switches, routers, hubs, and
remote access, 3Com is the second-largest company in the networking
business. In fact, the company may not even be the number two company
for the current quarter. Number three Bay Networks did $601 million in
revenues last quarter and sees sales going up sequentially, although
there are significant questions about whether or not the company's
router business (22% of sales last quarter) will further erode. A
sequential sales gain of more than 3% will put the company on par with
3Com for the first time since the Wellfleet-Synoptics merger that
created the company, an interesting turn of events indeed.
Although both companies have their individual issues, things get even
worse further down the networking food chain. Two weeks ago number four
in the industry, Cabletron, said it would do $330 to $340 million in
sales in its upcoming quarter, not counting the $70 to $80 million in
revenues from the Digital Equipment Networking business it recently
bought. Put another way, sales could drop more than 9% for Cabletron's
core business without clearing out an inventory channel that some
analysts believe is equally as bloated as 3Com's. The fact that the
company has laid off 600 workers in an attempt to realign its cost
structure is even more troubling that anything 3Com or Bay can offer up,
as it suggests that the problems Cabletron has encountered may still be
here next year. Number five Ascend is even more of a wild card, with
sales already down by more than 12% last quarter and potentially
slipping even more as pricing in remote access is destroyed by Cisco.
Despite this sustained downtrend in the industry, all of these companies
still are valued at more than two times trailing sales -- even though
profit margins at all but Cisco have gone below 15% -- with most seeing
profits below 10%. While certainly networking is not going to become a
thing of the past, as the industry continues to consolidate and demand
gets lumpier, these companies will command less generous valuations.
Even if 3Com, Bay Networks, Cabletron, or Ascend manage to right their
businesses, what new valuation paradigm will exist remains unknown. With
industry growth for the next two years estimated to be well below that
seen in the first part of the decade, investors involved in any of these
stocks should be careful that they do not just use historical multiples
as their guide but instead focus on what the underlying profitability of
these companies will be and what sort of value companies with similar
profitability get. The bloom may not be off the rose, but the halo has
certainly been removed from quite a few corporate heads."
Please note: This is my last post for 1997. I am going out of town(and cyberspace)for the holidays. Will be back to read what I've missed 1/4/98. Hope we all have a happier and more prosperus New Year!!
Paul |
