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The new year was supposed to be the year of Y2K. Or was it the year of the Asian bounceback? Or the year of Microsoft's comeuppance? Instead, events so far in 1999 have heralded the year of broadband -- the technology that will revolutionize the Internet by providing much speedier connections. First came news that Lucent (GE) NBC television unit, announced a new broadband version of its portal called Cyclone. Cnet couldn't have summed it up better when it proclaimed that "1999 is the year of broadband". These developments have investors scurrying to figure out how best to take advantage of this latest Net phenomenon. After all, cable and telephone companies are going to be spending tens of billions of dollars over the next two or three years on new equipment to upgrade their infrastructure and provide customers with either cable or DSL modems. Analysts consistently mention three companies that are likely to benefit: Cisco Systems (COMS). "LITTLE OVERLAP." So far, the race has been between the two behemoths of networks, be they data-based or telecom-based: Cisco and Lucent. Cisco, which dominates the data-networking equipment market, is just now starting to edge into Lucent's main market of providing telecommunications equipment to phone companies. "So far, there's very little overlap," says Sanford C. Bernstein analyst Paul Sagawa, who estimates that of Lucent's $30 billion in revenue, only about $2 billion comes from equipment that directly competes with things Cisco sells. "But Cisco is rightly moving in the direction of where the opportunity is [sales to telephone and cable companies], and that will soon be a major slice of their revenue," Sagawa says. Meanwhile, Lucent is just as aggressively moving into Cisco's meat-and-potatoes market of data networking, most notably by buying Ascend, which has produced cutting-edge router cards for phone companies. Analysts estimate that it will take Cisco close to a year before its competing product is ready for production. In addition, Lucent has long-established relationships with all of the Baby Bells, which buy much of their analog telecom gear from the ex-AT&T (T) division. The problem with both Lucent and Cisco, from an investor's perspective, is their price. A share of Cisco can now be had for $102.81, which is only about $8 below its 52-week high and gives the company a monster trailing 12-month price-earnings multiple of 86. Lucent is even more expensive, with a trailing p-e of 92, before factoring in Ascend's impact on its stock valuation. A far cheaper stock, and one that's just as much in the broadband race as Lucent and Cisco, is 3Com. While the other two companies are busy making switching equipment for the phone companies, 3Com's biggest source of revenue, about 50%, comes from selling modems. 3Com also sells switching and network equipment, but since its 1997 acquisition of U.S. Robotics, its primary business is modems. A COMMODITY. On the negative side, that's why 3Com's stock is valued lower by the market (its trailing p-e is 35). Cisco's gross profit margins are around 65%, because it can charge high prices for its proprietary router technology. But modems are for the most part a commodity. They can be made just as easily by a startup in Taiwan as they can by 3com. As a result, 3com's gross profit margins are appreciably lower -- around 45%. "There is the valid point that there should be some discount [in 3com's share price as compared to Cisco's or Lucent's]," says A.G. Edwards analyst Shebly Seyrafi, who points to an earnings disappointment in the fiscal third quarter of 1998 and 3com's lower margins as reasons for its lower multiple. "But they have their house in order and have executed very well in the last few quarters, and there's a lot of growth ahead of them." That growth will come primarily from new DSL and cable modems, which 3Com promises to produce as soon as technical standards are agreed upon by industry participants (which should happen by the end of the year, predicts Bernstein's Sagawa). As a new technology, these modems will command a much higher price point and accordingly higher profit margins than run-of-the-mill modems. The analog modem market is today valued at close to $6 billion, of which 3Com has the leading share, at 36%. Of the some 500,000 cable and DSL modems now in use, Motorola is currently the largest manufacturer. But you can expect that to change as 3Com takes advantage of its relationships with PC makers to bundle broadband modems into new PCs. Another high-growth area for 3Com is its Palm computing unit, which it also acquired when it bought U.S. Robotics. Although the division accounts for a bit less than 10% of the company's revenues, it's growing quickly. As of last July, 3com's Palm III held 63% of the handheld computing market, and it seems to be maintaining that share even in the face of an onslaught by devices based on Microsoft's competing software, called Windows CE. This summer, 3Com will start selling a new version, called the Palm VII, which includes a wireless modem that will allow Internet connections. That should help the product maintain or increase its popularity. BUYOUT BAIT? Probably the most intriguing part of the 3Com story is its attractiveness as a takeover target. Both Lucent and Cisco would benefit from owning 3Com's market share and could both bid on the company, especially while its shares are so comparatively cheap. Other potential bidders are wireless phone companies, such as Nokia (ERICY), which would likely love to build the Palm VII into their next-generation wireless phones. Even Microsoft could be a bidder, since it doesn't like being second in any operating-system market. A recent Microsoft-3Com agreement to bundle the new Windows 2000 operating system with all of 3Com's networking products shifted the rumor mill about a future merger into overdrive. So how can an investor play the coming broadband infrastructure spending spree? If you're willing to pay any price for a consistent growth stock, then Cisco is your horse. If you believe that Lucent's combination of marketing relationships with the Baby Bells and advanced technology will let it win the race, then a bet on Lucent would probably be wise. If you like cheap and undervalued, then 3Com is clearly the favorite. If you like a sure thing, it might be wise to own all three. Jaffe writes about the markets for Business Week Online |
Copyright 1999, by The McGraw-Hill Companies Inc. All rights reserved.