Long-term we are all dead, enthusiastically dead!!
Credit Suisse First Boston Corporation
CREDIT SUISSE FIRST BOSTON CORPORATION
Equity Research Americas
U.S./Technology/Data Networking
STRONG BUY
LARGE CAP
3Com Corporation (COMS)
Laundry List of Issues Have Investors Worried - Visibility
Will Not Improve Until End of Quarter
Summary
Four issues have impacted the stock: Intel's adapter product
announcement, fallout from a distributor's pre-announcement,
comments from Cisco on market dynamics, and the back-end loaded
nature of quarter. Of all these were are most concerned with
visibility and less concerned with the recent Intel, Cisco and Tech
Data issues.
Although not new, the back-end loading of FQ3 - over 50% of business
remains to be done in the month of February - creates significant,
albeit manageable, risk.
We believe that as visibility into May quarter increases, the stock
should perform better as investors look through the seasonally tough
FQ3.
While we share some near term visibility concerns, we remain
enthusiastic about 3Com's long term prospects; we still are some
near term risk in the stock and will become more aggressive buyers
as the visibility improves.
Price Target Mkt.Value 52-Week
2/3/991 (12mo.) Div. Yield (MM) Price Range
USD 38.3 $55 $0 None $14,102.1 $51-23
Annual Prev. Abs. Rel. EV/ EBITDA/
EPS EPS P/E P/E EBITDA Share
5/00E $2.30 16.7X 58% NA NA
5/99E 1.40 27.4 85% NA NA
5/98A 0.68 56.3 176% NA NA
Aug. Nov. Feb. May FY End
2000E $0.51 $0.55 $0.60 $0.64 May
1999E 0.24 0.36 0.35 0.45
1998A 0.47 0.01 0.02 0.18
ROIC (11/98) NA
Total Debt (11/98) $24
Book Value/Share (11/98) $8.02
WACC (11/98) NA
Debt/Total Capital (11/98) 0.8%
Common Shares 68.2
EP Trend2 NA
Est. 5-Yr. EPS Growth 25%
Est. 5-Yr. Div. Growth NM
1On 2/3/99 DJIA closed at 9366.8 and S&P 500 at 1272.1.
2Economic profit trend.
3Com is a leading provider of a broad range of networking equipment
including ac-cess devices (adapters, modems), systems products
(hubs, LAN switches and re-mote access concentrators) and handheld
devices (Palm Pilot). 3Com is the number 2 supplier after Cisco and
has strong manufacturing. and distribution strengths.
Key Points
3Com shares collapsed yesterday after concerns relating to four
particular issues surfaced - Intel products, Tech Data earnings
pre-announcement, Cisco results and backend loading. While we
believe most of these issues are overblown, we are still not able to
provide comfort that 3Com can make the quarter as it is simply too
early to tell. This is largely a function of how backend loaded this
quarter is (over 50% of revenues in the last month) rather than a
change in fundamentals. As is typical, the company is not providing
intra-quarter guidance and this is exacerbating the fear factor. In
our opinion, the stock is discounting a miss of a few cents at this
point and represents an attractive buying opportunity, albeit with a
significant degree of volatility attached for investors willing to
look through the current quarter.
There are four factors that have impacted the stock: 1) Intel
launched new adapter product/Analog Devices relationship
As discussed in our February 3, 1999 First Call note, we believe the
Intel product launch and associated benign pricing moves should be
read as a positive for 3Com.
We discussed this with 3Com and they do not view it as a material
change in the competitive environment.
Intel also announced a relationship with Analog Devices that could
have competitive implications for 3Com. The two companies will
develop a DSP core (due by 2H:99) which could be used for many
communications applications such as cable modems, xDSL platforms,
wireless devices, set top boxes, etc. This relationship has no near
term implications but needs to be monitored.
2) Tech Data pre-announcement
Weakness appears to be margin related with underlying problem
associated with direct-sales PC vendors taking share in the channel.
Tech Data's networking business about 18-20% of overall, but is not
experiencing undue pricing pressure thus we believe impact on 3Com
is only guilt by association (Tech Data is an important but not the
largest 3Com reseller)
PC weakness in distribution should be made up by direct PC vendors
which is a net neutral for 3Com. We will monitor the channel issues
as this could be a material factor going forward.
3) Cisco conference call/enterprise results
Cisco cited the month of December being slow with a recovery in
January. This likely means a slow start for 3Com (first month of
FQ3 is December) but this is consistent with expected quarterly
profile and, at the analyst meeting in January, 3Com suggested
business was picking up as expected.
Cisco cited strong two tier growth (run rate nearly doubling vs. a
year ago) which is well ahead of 3Com. We find little surprise in
the fact that Cisco is growing faster than 3Com and believe that
Cisco's growth comes more at expense of others than 3Com.
For the second quarter in a row that Cisco cited slowness in the
Enterprise business with spotty business by vertical market (i.e.
financial services not booming). 3Com has most of its business in
the enterprise but we do not view this as a new issue.
The Most Significant Issue
4) Back-end loading - inability to lend comfort has investors
spooked
The biggest issue (and the one that is the most real) is the high
degree of back-end loading - 3Com will do 50%-plus of its quarter in
the last month. While this is not different than expected, it
implies limited visibility until the last week or two of the
quarter. This is why we believe the stock will be choppy through
February.
Our read of the body language is that this remains a tough quarter
but the company is not changing the delivery of its guidance (i.e.
still not giving month to month guidance) nor do we get the sense
they are lowering expectations. We believe 3Com entered FQ3 with
somewhat of a cushion (don't show a 5 cent upside surprise in
November with out a bit of confidence in next quarter), but don't
know if it will be enough if things are getting tougher.
What Gets the Stock Moving - Time
With sentiment having shifted from positive to negative and the
stock having broken down, only better visibility will turn the stock
around. By the end of February, we believe investors will begin to
look through FQ3 to FQ4 which is seasonally stronger, has better
product momentum (Palm and adapters should be stronger), and
improving chances for operating margin improvement. 3Com needs to
build the confidence of the Street by showing they can manage the
numbers, thus we believe they have been setting expectations with a
bit of a cushion. Long term we remain enthusiastic about 3Com's
prospects and would look to improving visibility as the catalyst to
accumulate positions.
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