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3Com Corporation (COMS)
FQ2 In-Line- Systems Outlook More Cautious- Palm Remains Robust
Summary
FQ2 EPS of $0.37 vs. $0.36 slightly exceeded our $0.35 estimate with revenues
of $1.475 bln vs. $1.494 (E).
Adapters, modem and Palm provided revenue upside; deterioration in Systems
business (missed target by 15-20%) leads to revenue and EPS reduction; Our FY
2000/01 EPS now $1.23/$1.69 from $1.37/$1.72.
Palm exceeding expectations on both top and bottom line, business momentum
strong; Palm's valuations could exceed our original 5-10x revenue valuation
assumption; continue to own 3Com for Palm spinout in 1H:00.
CFO announces retirement by mid 2000, is a blow to 3Com, but sufficient time
for an orderly transition; expect no near-term disruptions.
Price Target Mkt.Value 52-Week
12/21/991 (12mo.) Div. Yield (MM) Price Range
USD 53.13 NA $0 None $18,542.4 $54-20
Annual Prev. Abs. Rel. EV/ EBITDA/
EPS EPS P/E P/E EBITDA Share
5/01E $1.69 $1.72 31.4X 123% NA NA
5/00E 1.23 1.37 43.2 158% NA NA
5/99A 0.68 0.68 78.1 252% NA NA
Aug. Nov. Feb. May FY End
2001E $0.34 $0.45 $0.41 $0.50 May
2000E 0.32 0.37 0.25 0.29
1999A 0.24 0.36 0.24 0.24
ROIC (11/99) NA
Total Debt (11/99) $30.33
Book Value/Share (11/99) $10.26
WACC (11/99) NA
Debt/Total Capital (11/99) 0.90%
Common Shares 349
EP Trend2 NA
Est. 5-Yr. EPS Growth 20%
Est. 5-Yr. Div. Growth NM
1 On 12/21/99 DJIA closed at 11,200.54 and S&P 500 at 1,433.43.
2 Economic 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 re
-mote access concentrators) and handheld devices (Palm Pilot). 3Com is the
number 2 supplier after Cisco and has strong manufacturing and distribution
strengths.
Investment Summary
FQ3 Results Were As Expected - Guidance Weaker
Excluding one time gains, EPS of $0.37 vs. $0.36 were 2 cents ahead of our
$0.35; revenues were a bit light but the composition was materially different
than expected - systems very weak, modem/adapters exceptionally strong and
Palm a blow out. The most noteworthy elements of the quarter were:
Revenue composition favored PC related and handheld (Palm) businesses which
were up 15% and 50% sequentially, respectively, while product delivery
slippages resulted in a very poor 12% sequential drop in systems. 3Com was
much more bullish on modems and adapters given the stability of the
competitive environment and improving profitability. Guidance for FQ3 was reigned in as 3Com missed key product shipment dates for
certain systems products and some Y2K fallout could persist into FQ3. Much
of the problem appears to be internal rather than external as 3Com is in an
increasingly challenging position in the core systems business having to
continually narrow its focus and rely on third party partnerships for the
total solution.
Hope for the future lies in the emerging segments - broadband access, VoIP,
wireless, home networking and LAN telephony - which combined account for
maybe 5% of sales, but collectively showed 47% sequential growth. 3Com's
best near term chances for success lie in broadband (especially DSL) and VoIP
segments, each of which should grow at better than 100% over the next 3 years.
Operational improvements - gross margins holding steady, balance sheet
showing unbelievable asset velocity 45 day DSO and 37 days of inventory and
stock buy backs continue. Channel inventory declined, providing some buffer
against the seasonally weak FQ3.
CFO departure - Long-time CFO, Chris Paisley, announced he would leave the
company in mid 2000. While his departure is clearly a negative for the company,
there is sufficient time for an orderly transition, and we believe 3Com has
appropriate depth in the financial organization to handle this transition.
Business Unit Review And Outlook
Overall, we are reducing our near term revenue projection by 2-5% in 2000/01
to reflect the deterioration in the systems business. Management guided FQ3
EPS to 24 cents range on lower revenue and higher expense growth vs. 36 cents
previously. Our FY 2000/01 EPS estimates are reduced to $1.23/$1.69 from $1.
37/$1.72. Exhibit 1 reviews the details of 3Com's three main business units.
Personal Connectivity - had a blow out FQ2 on strength of OEM business,
improving gross margins and 2+ quarters of cost cutting. This should
continue and 3Com's optimism for this business was clearly evident for the
first time in 2 years. Operating margins in this segment were above 20% in
FQ2 and should sustain about 15-20% on a normalized basis. While growth is
anemic, this is a cash cow segment that is being harvested and will likely be
an incredibly profitable business for the next few years.
Systems Products - had major shortfall due to tardy product delivering of new
CoreBuilder 9000 (8-slot version), associated software and modules. More
importantly, the delayed products hurt sales of associated stackable products
which typically accompany the sale of core platforms. We are very
disappointed with this business segment and consider it the key wild card in
meeting next quarter's objective. Mgt. is reasonably confident in its
ability to recoup the lost momentum but we need to monitor this very closely.
Our forecast assumes a modest recovery in FQ3, but flat performance in FY
2001.
Handheld (Palm) Products - business was well ahead of plan growing 50%
sequentially and over 75% yr-yr. The product portfolio was strengthened,
employee attrition has been controlled and partnerships with AOL, NOK, Sony
and MOT were established. We estimate this business could come close to $1
billion in revenue in FY00 and project nearly 50% growth in FY 01. What Happens Post Palm
In CQ1 3Com will sell ~20% of Palm to investors, retaining 80% which will
subsequently be distributed to 3Com shareholders. Once that is done (likely
to be 2H:00) Palm will no longer be included in 3Com's results. As shown in
Exhibit 2, the core 3Com business has had little if any growth (flat at $1.25
billion/qtr) and we are not expecting material changes (forecast 2% decline
in FY 01 revenue for core 3Com) in the near term. In fact, over the next 3
quarters, 3Com and Palm will prioritize infrastructure investment over
revenue growth, which means the company will have to re-invest in SG&A.
Although we feel 3Com will do this much more smartly than in the past, it
will mean sacrificing profitability in the near term.
This will mean 3Com's core business should generate operating margins in the
10-12% range, rather than the 12-13% range as has been the case in the past (see
Exhibit 3). On a longer term basis, the investments should enhance the
growth prospect of 3Com, enabling them to generate 0-10% top line growth over
the next 3 years.
CREDIT SUISSE FIRST BOSTON CORPORATION
Equity Research
Americas
BUY
LARGE CAP
3Com Corporation (COMS)
FQ2 In-Line- Systems Outlook More Cautious- Palm Remains Robust
Post the Palm spin-off, the financial profile of 3Com will be volatile on
quarterly revenue basis, reflecting the seasonality of PC connectivity
products, but generally stable from a profitability standpoint.
From a stock perspective, we would continue to own 3Com shares but this is
largely because its a low risk means of owning Palm. We have generally
assumed revenue multiples for Palm of 5-10x, but with current revenue
multiples of many communications equipment companies well above this (average
of 35x 2000 and 21x 2001) we believe Palm's valuation could be significantly
better than that. Moreover, the competitive position of Palm improved in the
last quarter as Palm struck relationships with Nokia and Sony, expanding the
potential for Palm devices in the smart phone and infotainment spaces, plus
MSFT continues to vacillate on its CE commitment. At 10x fiscal (June 2001)
revenue for Palm, investors are getting the balance of 3Com at about 1x
revenue; at 15x Palm would be valued $21-22 bln, more than all of 3Com, which
is currently at $19 bln. It is for this reason we would continue to by 3Com
shares believing the stock will continue to improve as the buzz on Palm stays
high.
Competitive Implications
Xircom (XIRC) - 3Com suggested it would have a response to Xircom's Real Port
product in CQ1 which is consistent with our expectations and about 2-3 months
behind XIRC's Real Port II launch.
Cisco (CSCO) - With large declines in the systems business and tougher
competition in the channel we believe Cisco is the biggest beneficiary of
3Coms market share loss in the small/medium business segment.
Efficient (EFNT) - 3Com suggested the DSL CPE business, while immaterial to
3Com's revenue today, will likely be the fastest growing of its new segments,
over taking cable modems during 2000. This is another data points suggesting
that DSL modem vendors are seeing the knee in the curve. |
