FYI.
This article is in the new issue of BusinessWeek, (available online):
How investors could get a chunk of the handheld maker's stock and pay little for parent 3Com
Anyone who staggered through PC Expo in Manhattan last week got a taste of Palm-mania.
Companies making software and applications for devices that use the increasingly
ubiquitous Palm Computing (PALM) operating system dominated the show.
Consumer-electronics giant Sony Corp. rolled out a personal digital assistant that uses the
Palm operating system, and cell-phone powerhouse Nokia has licensed Palm OS for use in
hybrid cell phones.
Palm and chief competitor Handspring (HAND) can't get product out the door fast enough to
meet raging demand. The ranks of developers making Palm applications have swelled to
82,000, compared with 29,000 only six months ago. That means more utility and even more
reason to buy the handhelds.
According to International Data Corp., consumers will have purchased 36 million PDAs by
2003. Most analysts think a good chunk, if not the overwhelming majority, of those will run on
some variation of Palm OS. And for every copy of Palm OS sold, the company collects
royalties in the neighborhood of 80% gross margins, calculates Cromwell Weedon equities
analyst Chris Sessing.
CLASSIC ARBITRAGE. If you think this sounds a bit like how Microsoft became a cash cow,
you're not alone. Palm has a "strong buy" rating from four of the seven analysts who cover the
stock. Those analysts looked prescient when Palm announced earnings of 3 cents per share
for its first quarter after spinning off in March from its parent company, networking equipment
maker 3Com. Those earnings topped analyst estimates of 1 cent per share and pushed
quarterly net income for Palm up 148% from the same quarter last year, to $16.9 million.
The solid numbers have driven Palm's stock 65% above its 52-week low of $19 7/8, which it hit in late June. Palm
closed at $32 7/8 on July 5. True, that's well off the stock's insane high of $165 shortly after Palm's ballyhooed IPO in
March. Still, Palm carries a steep price-to-earnings ratio of 355.
But there is a much cheaper way to buy Palm, and that's to buy 3Com (COMS) stock. 3Com announced on May 8 that it
would divest its 94.2% remaining ownership of Palm Computing to shareholders on July 27. Although precise terms
have not been announced, analysts believe each 3Com share will receive 1.5 shares of Palm Computing. 3Com closed
at $56 9/16 on July 5.
At current prices, that means each 3Com share buys just under $50 worth of Palm shares. Additionally, 3Com has
slightly more than $3 billion in cash on its books, or about $8.50 per share, available to invest in the company's projects.
If 3Com's cash is excluded, the value of the company's continuing operations runs at a mere $7 per share. It's a classic
arbitrage play, analysts say, and the market caps of the two companies tell the tale. The value of the Palm Computing
stock still held by 3Com as of market close on Wednesday was about $17.1 billion, vs. Palm's market cap of $18.2
billion.
SILVER LINING. 3Com's market capitalization was $20.2 billion. Subtract $17.1 billion and you have $3.1 billion -- the
total amount of cash 3Com has on hand. In other words, investors would get a chunk of a hot PDA stock and pay
virtually nothing for 3Com's existing operations -- if you factor in the pile of cash the company has to invest in future
growth. It's a pretty good deal considering that "for 3Com alone, our price target is $30 after the divestiture," says
Sessing. "We have a 'hold' rating on Palm, but we like 3Com as a way to get into the stock cheaply."
What would shareholders get in the basic 3Com stock? That's not entirely clear because the Santa Clara (Calif.)
company is undergoing a massive restructuring. The lack of clarity is likely part of what's causing the market's reticence
toward 3Com, which posted stock gains of less than 1% from 1998 to 2000 during the furious Nasdaq runup. Saddled
with dying businesses such as dial-up, nondigital modems and with a second-rate network router business, the
company has watched earnings slow and profits fade.
But there may be a silver lining to the cloud over 3Com. The company is aggressively targeting several product areas
with big market potential, including consumer digital subscriber line (DSL) and high-speed modem products,
networking equipment for small and midsize businesses, and remote access equipment for big Internet service
providers.
"When you dial into America Online, you have a 70% chance of dialing into a 3Com box. They are executing on their
stated restructuring plan. They will be putting a lot back into the business over the next year," says Sessing.
SPLIT DECISION. But the view on 3Com's prospects is not unanimous. Of the 20 analysts that follow the stock, 8 have a
"hold" rating and 12 have a "buy." "They are working through a restructuring process, and it's not clear where
that's...headed. They are talking about a return to profitability by the fourth quarter of 2001. We don't know exactly how
the new company will look as far as growth rates and margins," says David Toung, an equity analyst at Argus Research
who has a "hold" rating on 3Com.
So, what is 3Com's worth beyond the embedded Palm stock? "They have an ongoing business. I don't know if it's going
to be easy to figure out what it's worth, but it's definitely worth more than nothing, which is what the Street is valuing it at
right now," says Ara Mizrakjian, equity analyst at Robertson Stephens. In other words, the only way you would lose
buying 3Com is if the company manages to waste $3 billion in cash and fall off a cliff.
Salkever writes for BW Online in New York
EDITED BY BETH BELTON
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