Next time this analyst writes a report, she'll be in bed with 3Com CEO!!
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November 13, 1998 - 8:37am
Credit Suisse First Boston Corporation
CREDIT SUISSE FIRST BOSTON CORPORATION
Equity Research-Americas
Industry: Data Networking
STRONG BUY
3Com Corporation (COMS)
Key Points
Meeting with senior management yesterday suggested the company is not changing
near or long term guidance, they feel good about end market demand, product
cycles are strong while product transitions are nominal and the opportunity for
sustained margin improvement is still very good. Several new markets will begin
contributing to 3Com's revenue stream in 1999 however the three with the most
impact will be voice over IP, wireless capabilities and cable modem
opportunities.
The current quarter (Nov.) is on plan and our comments over the last two weeks
remain valid - we expect margin improvement to be driven by strong top line
growth (30% yr/yr), a favorable gross margin impact due to product mix and well
controlled operating expenses.
Price Target Mkt.Value 52-Week
11/12/981 (12 Mo.) Div. Yield (MM) Price Range
35 $40 - None $12,511.7 $22-45
Annual Prev. Abs. Rel. EBITDA/
EPS EPS P/E P/E Share
5/00E 2.31 15.1X 60% NA
5/99E 1.39 25.1 93% NA
5/98A 0.68 51.3 183% NA
Aug. Nov. Feb. May FY End
2000E 0.51 0.56 0.60 0.65 May
1999E 0.24 0.32 0.35 0.47
1998A 0.47 0.01 0.02 0.18
ROIC (8/98) NA
Total Debt (8/98) 24
Book Value/Share (8/98) $8.02
WACC (8/98) NA
Debt/Total Capital (8/98) 0.8%
Common Shares 358.5
EP Trend2 NA
Est. 5-Yr. EPS Growth 25%
Est. 5-Yr. Div. Growth NM
1On 11/12/98 DJIA closed at 8830 and S&P 500 at 1118.
2Economic profit trend.
3Com is a leading provider of a broad range of networking equipment including
access devices (adapters, modems), systems products (hubs, LAN switches and
remote access concentrators) and handheld devices (PalmPilot). It is the second
largest publicly traded data network equipment supplier after Cisco
Systems.
Tone of Business - Not A Lot Of Concerns
We held a dinner with the CEO of 3Com last night. There were three factors we
feel are relevant to the current quarter.
First, despite recent speculation, our level of concern about the November
quarter (FQ2) is less than the prior quarter. FQ2 has not shown any material
surprises relative to expectations with respect to pricing, unit volumes,
product mix, operating expenses, or end market demand. We believe this is
bullish indicator that the quarter is progressing on plan and that our $0.32 EPS
estimate is valid. We are assuming a 250 basis point operating margin
improvement.
Second, the interest level is high in the CoreBuilder 9000 switching platform
that has been entirely refreshed and is shipping in volume this quarter. Demand
is outstripping supply and the pipeline of new business opportunities based on
this product is now at record levels. The 9000 is important because it tends to
drag along stackable switches, hubs and adapter cards.
Third, operationally 3Com feels like it has a much better handle on its business
compared to the last twelve months. Internal systems have improved to give it
control of inventory and headcount while the benefits of supply chain management
are only now being felt. This increases our confidence that gross margins will
continue to climb while operating expenses will continue to fall.
Beyond the Current Quarter
We felt there was not likely to be a change in near term guidance as it relates
to the February quarter. Our expectations for sequential growth are modest
given the seasonal impact in the client and Palm business, but the systems
business is likely to remain strong and the opportunities in remote access
haven't sounded this good in over a year. The 9000 switch should provide a bit
of a buffer for next quarter (Feb) which is typically seasonally soft.
We feel there could be a lot of product, partnership and new market entry type
announcements coming over the next two quarters. Catalysts for the stock would
include customer authorized announcements of VoIP deals, cable infrastructure
and wireless wins. Alliances with wireless handset providers should coincide
with the launch of the next generation Palm Pilot products. LAN telephony
products are on the way. With the company feeling more confident about the
outlook, small technology acquisitions are a strong possibility.
Next Set of Growth Opportunities
We believe 3Com's incremental growth over the next 2-3 years could come from six
emerging market segments, some of which 3Com will have product for in 1999,
others provide a longer term opportunity. The six segments are:
Voice over IP (VoIP) - multiple RFPs in progress
Broadband access - cable winning over DSL
Handheld computers - the Palm has expanding possibilities
Home networks - announced deal with Epigram
Wireless networks - opportunity with TDMA vendors and on Palm Pilot
Storage Area Networks (SAN) - just launched products
Near term, we expect the three most important new contributors to revenue should
be VoIP, wireless and cable.
The best near term opportunities will be in VoIP, where 3Com claims a number of
wins as well as several large deals pending as all major carriers in midst of
procuring VoIP solutions. 3Com is exploiting relationships with Siemens and
Microsoft. We are still confident that 3Com will get significant business from
AT&T by mid-1999, however nothing has been announced. The second wave of
opportunity will become visible with IP (LAN) Telephony with early 1999 product
rollout for the small business market. This will leverage Siemens technology
and 3Com client products.
Wireless is clearly in its infancy and 3Com will play this in a number of ways.
The most sizeable opportunity would be providing the wireless data
infrastructure as networks transition to CDMA. Partnerships with MOT have been
established and 3Com makes a natural ally to other TDMA wireless vendors. In
Q1:99, a wireless LAN initiative will be launched for the enterprise followed by
wireless products for the consumer/home markets.
Cable is clearly winning over xDSL solutions in the near term and 3Com has
significant opportunity. 3Com is now beginning to ship against a TCI contract
and over the next six months cable headends will be deployed across an estimated
50 cities. There are lots of kinks to be worked out of the retail model but 3Com
claims tight integration of TCI specifications will reduce third party
involvement in the installation process, a key to getting the retail model to
work. 3Com has very aggressive market share goal of 40% in a year but could get
there given likelihood of OEM deals with PC vendors (stay tuned).
Bottom line: there are many reasons why growth could accelerate in 1999 for
3Com, independent of macro factors. However, at this point, its too early to see
concrete evidence of accelerated growth.
Palm Pilot - More Opportunities Than Expected
We are surprised at the diversity of Palm Pilot applications and features that
will be coming in the near term. The most important will be wireless as its
voice functions get integrated through a broader licensing program. 3Com is
clearly seeing more impressive growth in this business than previously expected
(now looking for sustained 100% growth over the next few years. This is due to
the fact that Palm sales have shifted from consumer to an enterprise purchase,
making the device more of a platform from which 3Com can add services. Along
with integrated wireless data (coming in next version) and wireless voice
features, Palm can now become an information resource, or a modified Internet
appliance. Expect more directions and partnerships on this product shortly.
Noteworthy data points
Expect many small, but no big, acquisitions over the next year to round out the
technology portfolio
Europe and North America are the strong regions for the company; 3Com is adding
manufacturing capacity.
Management's recent visits with enterprise customers suggest no near term Y2K
impact or budgetary diversion issues.
As much as two-thirds of revenue in 1999 could come from new products
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