From barrons/WSJ
February 23, 1999
Bulls Say 'Palms Up' For 3Com
By Carolyn Whelan
3Com used to be one of the hottest stocks in one of the hottest industries --
computer networking. Over the last two decades it has been a leader in
providing switches, routers and other equipment that allows computers to talk
to each other. Its stock price reflected those cheery prospects, hitting a high of
75 1/4 at the end of 1996.
But then, 3Com bought modem manufacturer U.S.
Robotics, and Wall Street has never gotten over it. Fears of
price wars in that notoriously commoditized business have
kept 3Com's earnings, and its stock price, trailing its peers
ever since.
Earlier this month, the stock lost 20% of its value after Tech Data, a distributor
of 3Com's adapter cards, warned of weaker than anticipated earnings.
Adapter cards, which connect PCs to networks, and analog modems account
for nearly half of 3Com's business. But they are now being built right into
computers and sold at retail, squeezing the manufacturer's prices and margins.
Also, the current seasonably weak third fiscal quarter (which ends this week)
has investors scurrying away -- and analysts remaining tightlipped. While
competitor Cisco Systems remains a stellar stock market performer, nearly
doubling since October, 3Com's shares have gone south again: At Tuesday's
closing price of 34 21/32, the stock is nearly a third off its 52-week high of 51
1/8.
"There's a lot of uncertainty. . . and I think that's reflected in the stock price."
declares Luke Szymczak, an analyst at Prudential Securities, who recently
downgraded 3Com stock to Hold from Accumulate.
But some fans of 3Com say that despite these short-term fears, the company
is in good shape, and is well-positioned in some very promising businesses.
"This is a big year for [3Com]," proclaims Scott Miller, an analyst with
Dataquest. "And Palm has all the momentum."
Palm refers to the Palm Pilot, a hot
product line that now accounts for 10%
of 3Com's revenues. Despite inroads
made by competing products using
Microsoft's Windows CE operating
system, Palm still accounts for seven out
of every ten handheld computing and
communications devices sold. 3Com's
volume in the Palm product line also is
doubling each year -- and licensing
deals with the likes of IBM are likely to
spur sales growth even more.
"The Palm business is extremely healthy," says Miller "And the margins are
very respectable." He declined to be more specific, but he thinks 3Com can
hold the line on pricing -- and hence, its profit margins in Palms -- for at least
the next year.
And there's good news beyond the Palm. 3Com's sales of hubs and switches
also are doing "reasonably well," reports Chris Stix, an analyst with S.G.
Cowen and Company. In addition to telephone companies, 3Com sells
equipment to nine U.S. Internet service providers (ISPs), including America
Online, and it is a key supplier to foreign ISPs, too.
Meanwhile, U.S. Robotics remains the leader in modem sales, but declining
profitability in analog modems should be offset by sales of more profitable
cable and DSL (digital subscriber line) modems, which provide high-speed
Internet access to the home. 3Com has already started selling cable modems
to Tele-Communications International and its new parent company AT&T.
And both Hewlett Packard and Dell Computer are integrating 3Com's DSL
and cable modem technology into their higher-end computers.
The high-speed communications market is expected to double between 1998
and 2003, according to Insight Research Corp. Similarly, the percentage of
U.S. homes with more than one PC should more than double, to 25% of all
households by 2001. 3Com's U.S. Robotics brand and distribution are likely
to be good springboards into those markets.
The company also is expanding in promising new businesses like wireless
broadband, Internet telephony and home networking. On Monday, 3Com
acquired NBX, which makes equipment to merge telephone and computer
networks. 3Com said the $90-million purchase will help it offer gear for voice,
video and data services over the same networks.
"If the new businesses and operational management gets under control, there's
a good story," says Stix of S.G. Cowen.
Finally, this quarter may have been an anomaly, because of widespread price
cutting and a big rush of orders for Palms and networking products late last
year. In fact, around 90% of 3Com's businesses felt price moves this quarter,
according to Stix. "A significant price cut is normal, but this came all at once,"
he claims. The upcoming fourth quarter, on the other hand, has historically
been much stronger.
For the value-minded, 3Com stock looks appealing. It changes hands at 25x
estimated earnings of $1.38 for the year ending May 1999, nearly a third of
Cisco's P/E and close to half that of Lucent Technologies, whose long-term
growth rate of 22 percent is less than 3Com's 25% projected earnings growth,
according to First Call.
There's also a lot of speculation about the company: Some expect it to release
a big new product; while others look for a possible spinoff of the Palm
business. In a rapidly consolidating networking business (Northern Telecom
recently bought Bay Networks and Lucent is acquiring Ascend
Communications), some say that 3Com, too, is ripe for acquisition,
too--perhaps by a European manufacturer like L.M. Ericsson, Siemens or
Alcatel Alstholm.
But whether that happens or not, some analysts are looking for a strong
recovery in the shares, with price targets upward of 60.
"We believe the recent decline in stock price presents investors with an
attractive opportunity to buy 3Com stock," wrote analysts Patrick Houghton
and Natarajan Subrahmanyan of Sutro & Co. in a recent report.
Of course, there could be volatility in the short run, especially as 3Com
prepares to report earnings next month. Slower growth in networking could
hurt sales, as could a slowdown in PC shipments. And some of those
promising new businesses require capital investments that may not pay off for
years.
Also, bloated inventories and operational problems have long dismayed
analysts. But with veteran Bruce Claflin appointed chief operating officer last
July, the situation already is improving. Claflin, a former top executive at
Digital Equipment and IBM, is respected throughout the industry and the
Street.
"Claflin has set some pretty aggressive goals that should have a significant
impact," says Stix.
If he can get costs down and margins up, then the fast growth of 3Com's most
promising products should do the rest.
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