This is from Briefing Com: (sorry it's a bit hard to read)
Updated: 12-Jun-98
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Briefing.com.
This week's topic: Networking Companies
Panelists
Scott Heritage, Vice President, Equity Research at UBS Securities.
Patrick Houghton, Senior Vice President, Equity Research at Wheat First Union.
Matthew Barzowskas, Vice President, Networking Analyst at First Albany Corp.
Q&A
Briefing: What factors have contributed to 3Com's poor stock performance? Can 3Com position itself
to compete in the high-margin growth area of the telecom equipment market?
Scott Heritage: 3Com has been plagued by several things in the last year. Two of the most significant are related to the
purchase of US Robotics in June 1997. The first important issue was excess inventory in the channel - that is product was
being shipped to distributors even though end-users weren't taking the products. We are just now beginning to see this turn
around. The second big issue has been weakness in the modem business. The was much hype surrounding 56K modems which
did not materialize largely because there was no industry standard. There were standards in the lower speed modems, but not
at the higher speed modems, so many ISPs and consumers alike did not upgrade because of the compatibility issue. There now
is a 56K modem standard but the modem market has remained weak. We see it improving in the second half of this year.
3Com would like to participate more in the service provider market and to a certain extent is making steps in that direction. We
think that partnerships alone will not allow them to become a force in this market, but rather it may be necessary for them to
make a major acquisition to become a significant player. The flip side of course is that one of the telecom companies will
acquire them, but we don't think that they are the most attractive candidate, although we wouldn't totally dismiss the possibility.
Patrick Houghton US Robotics accounts for a majority of 3Com's poor stock performance because of overhang from the
new 56K standard and weakness in consumer modem sales. Most new PCs are shipped with imbedded modems and Lucent
has a dominant share of that market, followed by 3Com and Rockwell. 3Com is fighting to gain market share in imbedded
modems because there is less demand for stand alone modems which are sold through the consumer channel. where 3Com
currently has a dominant market share. 3Com also dominates the market in Network Interface Cards (NIC). In its system
business, which represents about 40% of 3Com's revenues, its big challenger is Cisco. Most PCs are still sold to enterprises
and virtually all these PCs sold into the enterprise get NICs installed. Where the two companies are meeting is in the
workgroup hubs space and in the wiring closets, a market that is now being challenged by Cisco, which is moving out of the
network and into the wiring closets. This is clearly making the systems business much more competitive for 3Com.
3Com has entered into a partnership with Siemens and Newbridge Networks with the Carrier Scale Internetworking (CSI)
initiative . The important factor with CSI is that it scales MPOA (Multi Protocol Over ATM) from the LAN to the WAN for
the telecom market. It is not clear at this time how much 3Com will benefit from this partnership and the success of the
triumvirate will depend on their execution.
Matthew Barzowskas: First and foremost, investors have been turned off by 3Com's disappointing revenue and earnings
growth. Among the contributing factors for the disappointment have been tough pricing pressure at the low end of the market,
slower modem sales, and difficulty integrating U.S. Robotics' portfolio of products at a time when both companies had
excessive inventory in the channel, and modem sales slowed. 3Com is currently in the last quarter of its inventory restructuring
plan, but given tough industry conditions, is still hoping to reduce inventory levels even lower than its stated objective.
To maintain its position as a leading networking provider, 3Com will have to cater to the telco market. At the moment, 3Com
lacks the full product suite that is necessary to compete effectively in this area, yet its acquisition of U.S. Robotics has given it a
channel to the telco environment as it has provided 3Com with a total control remote access hub. Currently, 3Com does not
have ATM or frame relay products, but it is working with Newbridge Networks to provide these offerings.
Briefing: Is the Tellabs/Ciena merger a setback to Cisco given its focus on becoming a total solutions
provider in the telecom equipment market? How do you expect Cisco to respond?
Scott Heritage: Tellabs/Ciena merger is certainly not a setback for Cisco because their business is a not a direct threat to
Cisco's. In fact, this merger might even be a positive for Cisco as their businesses are complimentary.
Patrick Houghton Ciena is a very good fit with Tellabs and it is important to understand the benefits of this merger. Layer 1 of
the OSI model is the transport layer which is the strength of both Ciena and Tellabs. Tellabs owns 65-70% of the core of the
Telco data network with its 3/1 digital cross connects. Tellabs brings three important strengths to the merger - long and trusted
relationships with the RBOCs, a huge sales and support organization, and expertise in managing bandwidth, all of which Ciena
needs. In the near-term, Ciena brings new products for the Tellabs sales force, but in the long-term, Ciena brings Tellabs the
ability to manage bandwidth optically rather than electronically. Cisco operates at layer 3 where it dominates Internet Protocol
(IP) with its large core routers and is building its share of layer 2 with its ATM switches.
It is clear that Cisco is focused on the Telecom equipment market and needs to increase its products and market presence with
the Telcos. A bold strategic move would be to acquire the Tellabs/Ciena combination. Cisco has a $9 billion revenue run rate.
If they are to continue to grow at 30-50%, the enterprise market isn't large enough to sustain that level of growth so it has to
come from the $200 billion telecom market. Even at the low-end of that growth range, in two years, Cisco will be the size of
Nortel and in four years, the size of Lucent. Cisco has an $80 billion market cap. Tellabs/Ciena combined have an $18 billion
market cap. If Cisco bought Tellabs, it would be about the same proportionally as the Cisco/Stratacom acquisition two years
ago. For Cisco, it is important to have the market access that Tellabs provides and we believe that the Tellabs acquisition of
Ciena makes Tellabs an even more attractive takeover candidate for Cisco. Moreover, the acquisition could be neutral to
slightly accretive to Cisco's earnings.
Matthew Barzowskas: Voice switch players such as Lucent, Northern Telecom, and Ericsson, are looking to be more
aggressive in the data environment, and for that to happen, they have to buy the necessary equipment. As a result, acquisition
activity is picking up. With respect to the Tellabs-Ciena merger, it is a sign of things to come as point-product players will have
to combine product offerings to compete on a more level playing field with larger companies such as Lucent and Cisco.
Overall, we don't see this particular deal as a setback to Cisco since its size alone has already provided them with a channel
into the telco space. Thus, the most likely response from Cisco will be to continue its strategy of buying smaller, point-product
players, and taking advantage of its massive distribution channel.
Briefing: Which networkers are likely takeover candidates as telecom equipment makers race to
provide telecom companies with a single network that can carry voice, data, and video?
Scott Heritage: The three networkers and telecom equipment companies that we think are probably most ripe for takeover
are Bay Networks (BAY), Ascend Communications (ASND), and Advanced Fibre Communications (AFCI).
Patrick Houghton Ascend (ASND) is a likely candidate because of Cascade's strong frame relay and ATM products and the
fact that they have no strong alliances with any large partners. If Newbridge Networks (NN) shows any weakness in its
alliance with Siemens and 3Com, they could be a good candidate. FORE Systems (FORE) is another potential takeover as
they have just come out with what looks like a very good ATM switch. I think that the LAN game is over, Cisco won and
consequently, Bay Networks (BAY ) and Cabletron (CS) are not very attractive candidates.
Matthew Barzowskas: Bay Networks, Ascend, and Fore Systems are the most likely takeover candidates, yet each would
complement an acquirer in a different way. Bay Networks would be the most logical choice for telecom equipment providers
wanting to get more aggressive in the enterpise space as it offers a lot in the way of product portfolio, customer base, and
distribution channels. If looking to be telco-specific by providing infrastructure for the service providers, then Ascend would be
a better fit since it has the broadest end-to-end solutions. Finally, if looking for ATM technology, FORE Systems would be the
likely target since it is a leader in the enterprise space and possesses the technology necessary to channel into the telco space.
Briefing: Which stocks are you recommending and/or avoiding?
Scott Heritage: In the networking sector specifically, we have a BUY recommendation on Ascend Communications
(ASND), Cisco Systems (CSCO), and Xylan Corporation (XYLN).
Patrick Houghton I have BUYS on the following: Cisco (CSCO), Tellabs (TLAB), and Newbridge Networks (NN). I
have a LT BUY on 3Com (COMS), and I have OUTPERFORM on Northern Telcom(NT).
Matthew Barzowskas: We have BUY ratings on 3Com (COMS) and Cisco (CSCO). Ascend (ASND), because we think
it is fairly valued, is rated NEUTRAL. Similarly, Bay Networks (BAY) and Fore Systems (FORE) are also rated
NEUTRAL since we feel any impending acquisition has already been built into the stock price. As a derivative of networking
growth, we think there is an opportunity in the network management and security space, and have BUY ratings on Concord
Communications (CCRD) and CheckPoint Software (CHKPF).
Regards
Pheonix |
