"Is 3Com Trying to Create a Bidding War Between Ericsson and Siemens?"
"An Interview with Michael Murphy of the California Technology Stock Letter"
StockHouse: You put out a recommendation that 3Com [COMS] will be taken over
by the end of the year?
Michael Murphy: We did. We just recommended the stock. It was a long internal
debate. Because if they're not taken over, they're not in the best possible position.
We did, in fact, recommend it [the takeover]..
StockHouse: Then why is the stock price continuing to head south?
Michael Murphy: I think it's primarily because they are perceived as having lost
the battle against Cisco, at the center of the network. So even though they're still
the #2 data networking company, nobody can figure out how they're going to win
against Cisco as a stand-alone operation. They obviously don't have the telephony
side of this, at all, which Cisco now, of course, has - and which Lucent began there
and now is assembling the datacom side. Nortel has already done that. They're
(3Com) not in a position to become a broad range supplier. The modem side of their
business, and for that matter, the NIC, the network interface cards, that's a
profitless biz. On a price-revenues basis, the stock sells for quite a bit less,
because a big chunk of their revenues are kind of - nobody can figure out how to get
them profitable.
StockHouse: Isn't 3Com at around 1X revenues?
Michael Murphy: They're close. They're very, very close. One times projected
revenues; 1.3 times historic. It is ridiculous, I agree. But the problem is - if you look
at the quarterly revenue growth - it's a slow recovery. They had a horrible fiscal '98;
they earned 8 cents a share. The May (4th) quarter looks like it will actually be
down from the February (3rd) quarter, when they did 25 cents. The earnings aren't
particularly growing. A $1.10 for this May. Next year, maybe they do $1.20 to $1.45
- is what we were calling for - say $1.30. That's 20% growth. You know, the
business is growing faster than that. So they're losing market share. There are
some positive things you can say about 3Com. They actually have very good
products up against Cisco. Products head-to-head against Cisco are pretty good,
even though they've never really figured out how to market them. They do have
some substantial presence in the retail channel, with both the US Robotics name
and now the Palm Pilot name. And you could leverage both of those quite a bit.
StockHouse: So, what is their problem in this area?
Michael Murphy: They haven't figured out a way to
make money off of them very much. But, Palm has
certainly been a successful product. And US
Robotics? It's not easy to keep a retail channel
happy. US Robotics pretty much does. The retailers
we talk to don't hate them, the way they hate
Diamond or something like that. It's tough. They're
very sensitive to who you're selling stuff to, and
where the competition's coming from, and Internet
sales and all those other…it's just difficult. They
seem to have a good rep in the retail channel, US
Robotics still does. For somebody who needed a
name that the home user or the small office/home
office would immediately recognize, and that would
be relevant to them, US Robotics is a pretty good
name.
StockHouse: But 3Com paid around $8 billion for
something that's now valued around $2 billion?
Michael Murphy: That's probably true. It was a
terrible acquisition.
StockHouse: So, are they still being punished for it?
Michael Murphy: Oh yeah, because they haven't been able to figure out how to
get it profitable. I don't know anybody who thinks that 56k-modem profitability is
going to get any better. Now what's next? Now you have to move towards DSL and
cable modems. They (3Com) seem to be not particularly charging fast in those two
areas. Everybody can see the handwriting on the wall. They've got this big piece of
their sales that they paid a hell of a lot of money for, that may not be profitable.
Ultimately, the franchise may turn out to have made sense. But as of this minute, I
just think it's a loser.
StockHouse: What's your estimate of the break up value? We've heard around $36.
Michael Murphy: Oh, actually, I'd make it higher than that. I think it's of that sort
of value to somebody who has to still go in and deal with the parts of the company
that aren't useful. My guess is that you could break it up for substantially more than
that - probably in the $40 to 50 area. I say that, because I think you could find a
buyer for US Robotics who could leverage the name and the retail channels.
Somebody who's not in the US market and needs to get in. Palm Pilot is clearly a
successful product, and that could be sold. Then you can sell the traditional
enterprise system and carrier systems as one or separately. You might be able to
sell both of them to an Ericsson or an Alcatel or maybe to Lucent.
StockHouse: Is Ericsson really talking to 3Com, or is this some rumor making its
rounds around Silicon Valley?
Michael Murphy: It is a rumor that we heard from somebody who should know
what's going on. I think 3Com has talked to a lot of people over the last 6 or 7
months. Part of those talks, I think, were in sort of alliance discussions to see what
happened. But Ericsson, I believe, is visiting them in the Valley and talking with
them.
StockHouse: Currently?
Michael Murphy: About 3 weeks ago.
StockHouse: Wasn't there a rumor, a short while ago, that Siemens was going to
acquire a 3Com division?
Michael Murphy: Yeah, that's true. It happened. Yet Siemens is going to make
acquisitions, and 3Com has a huge joint venture with them. But you're right, nothing
has happened. It's always hard from the outside to tell what's going on. One reason
that Ericsson might have been invited in for discussions is to get Siemens off the
dime. Who knows? With Bay Networks taken out, and nobody's going to take out
Cisco, there's really only one broad-base company to buy, and there are about 5
buyers out there. Somebody gets them, and then whoever else is out there, doesn't
get them. Lucent must be tempted. If you're Alcatel or Siemens or Ericsson or
Nokia, you're looking at this and saying, "If I don't get 3Com, there's nothing left to
buy. If Lucent takes them, we're gone."
StockHouse: One analyst told us that, because of the recent Qualcomm
settlement, Ericsson wouldn't be buying 3Com, at this time.
Michael Murphy: What they've [Ericsson] done is they've come to an agreement
on what the next standard for digital cellular will be. But that's the input to the
system. That's the device in the hand. And Ericsson right now is pretty good at the
device in the hand, and the wireless network. They don't have anything beyond that.
They've got to decide here, very soon, if they're just going to be the niche supplier of
the device in the hand - competing essentially against Nokia and Qualcomm and
Motorola - or if they're going to try to provide systems that go more toward
end-to-end, as well as just access, for which you need switches and backbones
and that kind of stuff. The problem is a lot of the recent contracts, for example, with
Cisco, is the Belgian telephone system, which you know is right in the heart of
Europe. That must have been such a wake up call for Ericsson and Siemens and
Nokia. Because here is Cisco in there, getting the whole damn thing. They're
getting to reconfigure the whole thing. And all of a sudden Ericsson's saying, "Uh
oh. Am I a supplier to Cisco, or am I an independent communications company?" It
really is now or never for these guys. You get one chance during the next 12
months to decide, and that's it. So, I don't think the two relate. Ericsson does have
a lot of work to do on the digital cellular side, to continue to be competitive in that
area with the new standards. But from a strategic point of view, they also have to
make this other decision, conscious decision. And I really doubt that the one would
block them from doing the other.
StockHouse:Do you think 3Com has seen its bottom, at this point, and would now
head higher?
Michael Murphy: I don't know. If you look at tech stocks, what we do is we
calculate this downside risk value thing. It's sort of 1.5 times book value, which
would get you down to about $14. Just on pure book value, it's one times sales,
which would get you on reported sales down to about $18. It's 1/3 of the growth rate
times the earnings, which would actually get you way down around $7 or $8. But
say somewhere between $14 and $18 is the absolute total-disaster-catastrophe
bottom. In a sharp market downturn, this summer, if you got the usual summer
sell-off, and it came in a context with no news, no acquisition news, and a kind of a
crummy August quarter, which is typical of 3Com - because it's a summer quarter.
I guess you could get it into the high teens. But I don't think there's a lot of risk
down from here, just because. Because even though a lot of the sales are modems,
the sales are worth a lot to other companies. And at some point in here, they step
in. I think the problem, at this point, more is the other way around, which is 3Com's
really not willing to sell the company for $30. I doubt they're willing to sell it for $30.
So somebody has to swallow hard, because they have to pay a pretty big fat
premium to the current price. So we'll see what happens. If the tech market doesn't
fall apart, yes, we've seen the bottom. If the tech market falls apart, we may have a
$3 risk in here, but that's not a lot. That was another reason we made the call. We
thought that the bulk of the price-risk of it taken out. There still may be some
time-risk here, because this the kind of stock that can go dead for...
StockHouse: Like it has done since March?
Michael Murphy: Yeah, and it can stay there. They report the May quarter - they
do 25 cents or 23 cents or whatever - great! And then, they say that the August
quarter, which is the summer quarter, is going to be the usual kind of punky, and
they do another 23 cents. And you're already out to the November quarter before
you see a good quarter, which will be reported in December. So, from the
professional portfolio manager's point of view, they look at that and they think,
"God, it's stuck. It could be dead in the water for another 6 months. I can't afford to
own that." And it just sits there. So I think we have some time-risk. I don't think we
have very much price-risk at all.
StockHouse:What should we expect between now and the time 3Com reports on
their May quarter?
Michael Murphy: We should see a move up. They're going to be at the Hambrecht
& Quist Technology Conference (San Francisco: April 27th). They're going to look
awfully cheap, relative to everything else they need. What they really need at this
point is management to explain two things: One is, how are going to continue to
compete with Cisco on the enterprise and carrier systems? What's the strategy
there? And the second is: How are they going to wring some profitability out of the
client access business - the Ethernet card and the US Robotics modem? Those
are the two big questions. If they could give people a plausible scenario on just one
of those two, you'd probably see the stock move up. If they could do it on both, I
think you'd see the stock back at $30 in a hurry. But they're going to have to find a
set of investors who are willing, if necessary, to be patient. Basically, it's become a
value stock.
StockHouse:The Internet message boards are calling for the CEO's head.
Michael Murphy: Well, that's another reason to sell it. Eric (Eric Benhamou, CEO
of 3COM) is - hindsight's beautiful, but at the time, we said the US Robotics
acquisition was a bad idea. And, it's been a real catastrophe. Not only in the
financial sense have they way overpaid for it, but also they wrenched their strategy
around them. Maybe they didn't have a choice. But they wrenched their strategy
around them, and said, "We're not going to compete with Cisco at the center of the
network. We're going to drive intelligence out to the edge. And so we're buying US
Robotics." Well, it has turned out, as the systems have been built out, that
intelligence at the edge is not what people are looking for. What they're looking for
is very high-speed backbones with a minimal number of switches between the
backbone and their desktop - not intelligence at the edge. People are now talking
about essentially, practically dumb terminals at the edge with everything on the
Internet, because they have the high-speed access. The world has walked right into
the Cisco model, and not into the 3Com model. So yeah, people are screaming.
You have got to give them (3Com) credit for a couple of things. They had a terrible
1998, and they have stabilized the earnings. They're not growing, I admit, but they
have at least stabilized them. Positive cash flow - we're not looking at a disaster
here. And they have continued to spend the bucks on R&D, which is really
important. They only report, in earnings, a little over $1, and they spend about
$1.70 a share in R&D. They must have been awfully tempted to cut R&D and report
better earnings, but credit to Eric, he didn't do it.?
StockHouse: Does 3Com meet your minimum requirement of generating at
least 50% of their revenues from products they've created in the past three
years?
Michael Murphy: Oh, it's way over. I haven't asked them that, but I would
guess the number is 80% plus, and it could be almost 100%. That's partly
because of the speed with which the modem business changes. That whole part
of their business, 56k modems, is basically brand new. But it's also because the
drive for integrating functions, new functions, on the enterprise and carrier side,
have led them just to continually introduce new products. I don't think they sell a
router that's 2 years old. And so, it could be close to 100%. And you don't get
there without spending the dough on R&D. You have got to do it. He has done
that. The alternative, which we've seen other companies do, like Apple, is slash
R&D, report better earnings, have your stock go up, but consign yourself to a
niche - then the company just kind of niches away. It's just stuck there. I think
he's maintained the underlying value of the company, although at the expense of
current earnings, and obviously at the expense of stock price.
StockHouse: If 3Com has a bad quarter, do you think they're going to go into
takeover play?
Michael Murphy: Absolutely! This is their fourth quarter. Expectations are
modest, 22 to 23 cents, something like that. If they can't do that in the 4th
quarter, right before the summer quarter, I would think, first of all, the stock
would go down, and secondly, Eric (Benhamou) will sell the company. They just
would have to.
StockHouse: Thank you very much.
stockhouse.com
Mang |
