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Technology Stocks : 3Com Corporation (COMS) -- Ignore unavailable to you. Want to Upgrade?

To: Mang Cheng who wrote (26628)	12/26/1998 6:20:00 PM
From: Wigglesworth	Respond to of 45548

CREDIT SUISSE FIRST BOSTON CORPORATION 12/23/98 3Com report Equity Research-Americas Industry: Data Networking STRONG BUY 3Com Corporation (COMS) Key Points FQ2 results of $0.36 vs. $0.01 vs. $0.32E due to dramatic operating margin leverage. Should satisfy all whisper numbers and result in estimate revisions towards the high end of the range. Outlook remains bullish as PC and networking demand strong across the board. We believe 3Com will now enter several new markets in 1999 that will provide a sustained recovery. Changes to the long-term financial model are being made for the right reasons - gross margins up due to product/mfg. efficiencies and operating expense increase due to fund new product opportunities. Price Target Mkt.Value 52-Week 12/22/981 (12 Mo.) Div. Yield (MM) Price Range 48.625 $50+ -- None $17,903.7 $49-22 Annual Prev. Abs. Rel. EBITDA/ EPS EPS P/E P/E Share 5/00E 2.30 2.30 21.1X 75% NA 5/99E 1.40 1.39 34.7 117% NA 5/98A 0.68 71.5 236% NA Aug. Nov. Feb. May FY End 1999E 0.51 0.55 0.60 0.64 May 31 1998E 0.24A 0.36A 0.35 0.45 1997A 0.47 0.01 0.02 0.18 ROIC (11/98) NA Total Debt (11/98) $24 Book Value/Share (11/98) $8.31 WACC (11/98) NA Debt/Total Capital (11/98) 0.8% Common Shares (mil) 368.2 EP Trend2 NA Est. 5-Yr. EPS Growth 25% Est. 5-Yr. Div. Growth NM 1On 12/22/98 DJIA closed at 5192.3 and S&P 500 at 1203.6. 2Economic 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 remote access concentrators) and handheld devices (PalmPilot). It is the second largest publicly traded data network equipment supplier after Cisco Systems. Summary and Investment Conclusion Results were way ahead of all expectations (beat consensus by 5 cents) due to higher gross margins, offset by higher spending levels than expected (revenue was in line). We view FQ2:99 as a validation that 3Com has significant potential to expand operating margins without having to achieve extraordinary revenue growth objectives. There are minor changes to taxes, share count, revenue levels, which are noise level - the higher gross margins are sustainable and product flow remains excellent. While 3Com modestly modified its long term operating margin target, and some may be concerned with this change, this has no impact on EPS in the next six quarters and will likely result in better revenue growth in the long term. Our estimates remain at the high end of consensus and we continue to think 3Com has one of the better momentum stories for 1999. We believe these results will be viewed favorably as the stock was discounting an earnings surprise but not of this magnitude and it is likely that estimates will move towards the high end of the range. However, the stock has been a champ lately and is do for a breather, especially given the likelihood that seasonality will cap near term upside surprises. We remain bullish on the prospects for the stock over the next 12-18 months as 3Com will likely produce some of the highest EPS growth in the industry (105% in FY 99 and 65% in FY 00) due to potential for significant (500 basis points) operating margin expansion. Take Aways from Q2:98 Results 3Com has moved beyond recovery. Results suggest both strong product recovery (over 60% of sales were from new products) as well as limited pricing pressure. With systems sales were up 9% sequentially and client access up 10%, 3Com cited PC sell through (good throughout the entire quarter) and no delays in networking projects (as some had feared) as the key drivers. Unlike FQ2, Palm Pilot was not the only growth engine - systems sales were helped by the new ATM and gigabit CoreBuilder switches and new account activity with large Enterprises was the best its been in years. Operational Efficiencies. Beyond product momentum, operational efficiencies were evident as operating margins rose over 300 basis point, gross margins improved on systems and client products, inventory fell for the third consecutive quarter and channel inventory remained constant. These are all sustainable. We believe 3Com now has better visibility into its channel and has greatly expanded its reseller base (from 40K to 67K resellers) Solid opportunity over the next year. As we highlighted several times in the last month 3Com will enter 6 to 7 new product categories - voice over IP, LAN Telephony, storage area networking, cable modems, wireless, home networking - in 1999 that its was not in 1998. We look for these opportunities to contribute about 10-15% of sales calendar 1999, with VoIP and broadband being the largest contributors. Changes in the long-term financial model. 3Com revised its long term (3-year) financial model in a manner that slightly reduces the long term operating profit margins (OPM) to a 15- 18% range from 16-20% range largely because of increased spending to fund product development efforts in new market segments, offsetting an increase in expected gross margins. We believe there are three important points: This has no impact on the EPS in the near term as 3Com's OPM (currently in the 11% area) is still well below its revised long term model. The change is happening for the right reasons - gross margins are rising due to new products/manufacturing efficiencies and spending is increasing due to 6 or 7 new product opportunities that 3Com wants to fund. The accelerated spending should result in a higher than forecast top line growth rate. We are assuming about 20% top line growth and see the potential for 20-25% if these new product/channel initiatives are successful. Estimate revisions It is likely, in our opinion, that EPS estimates will be revised upward and move more towards our $1.40 EPS that is the high end of the consensus range. The company guidance for FQ3 called for sequentially flattish earnings, but this is off a base that is 5 cents higher than investors anticipated for FQ2. While there is some minor tweaking to the model, we have made no significant changes to near term estimates. Our estimate for fiscal 2000 ($2.30 on 20% top line growth) is likely to be at the high end of expectations ($1.90-1.95 consensus) which is a function of our belief that new product momentum at 3Com can be sustained. Issues To Watch For As always, the stock will be subject to factors that could have a negative impact on its near term trading pattern. Seasonality. FQ3 is always seasonally difficult and will likely be more so this year given the expected sequential decline in Palm Pilot sales, pricing adjustments and increased spending levels. We do not believe there is anything new in 3Com's comments about FQ3 so despite the FQ2 margins upside we have not changed our FQ3 EPS of $0.35 per share. Pricing. The first calendar quarter will likely be the period of price adjustments across multiple markets - modems, adapters, remote access, switching - which will probably cause above average volatility in the stock. 3Com is generally assuming 15-20% pricing reductions, with some systems products in a slightly higher range.