Technology

Is 3Com Meshing Yet?


3Com's (COMS) history is littered with failed efforts to sell modems, routers, Palm handhelds, and even Internet radios. But two more recent bets by the networking gear maker are beginning to pay off, say several fund managers.

In the most recent fiscal quarter, which ended Nov. 30, 3Com cut its net loss to 3 cents a share, from 13 cents a year earlier. Its share price has gained more than 25% so far in 2006 (it closed at $4.55 on Jan. 23). This is occurring amid buying by funds that anticipate 3Com will be generating positive cash flow by yearend.

Although 3Com shares trade at a fraction of the price they commanded five years ago -- and the company hasn't turned a profit since mid-2000 -- a two-year-old joint venture in China and the 2005 acquisition of a security gear maker are increasingly bolstering the bottom line (see BW Online, 3/26/03, "3Com's China Strategy").

REPAIR JOB. Both were the handiwork of CEO Bruce Claflin, who took over at the beginning of 2001 after 3Com had completed its most damaging deals, like the infamous $7.3 billion acquisition of modem and Palm maker U.S. Robotics and the $80 million purchase of Kerbango and its eponymous Internet radio device.

In the latest zigzag, 3Com announced on Jan. 11 that Claflin would retire for personal reasons as soon a successor can be found. Analysts say 3Com is likely to choose an outsider, but it hasn't yet floated any candidates. Whoever takes over will benefit from Claflin's cost cutting and savvy dealmaking, which have helped 3Com boost margins.

But the successor also will have to do better in repairing external relations with big corporate buyers put off by a pattern of twists and turns, says Zeus Kerravala, a Yankee Group analyst who follows the network-equipment market. "They need to bring in someone who can bring a new level of credibility," he says.

CHINA BET. The new CEO also should strike a partnership with a company such as Electronics Data Systems (EDS), IBM (IBM), or Accenture (ACN) that installs and designs huge networks, Kerravala adds.

Investors haven't been paying much attention to the joint venture, known as H-3C, with Chinese telecom-equipment vendor Huawei Technologies. Under the 2003 deal, 3Com paid $160 million for a 49% stake in the venture and shares in its profits of sales in China and Japan. 3Com can also sell the low-price networking products made by H-3C in other markets including the U.S. and Europe.

The venture was overshadowed initially by a lawsuit filed by rival Cisco Systems (CSCO) against Huawei for intellectual-property violations just before the deal was launched (see BW Online, 5/19/03, "Cisco: In Hot Pursuit of a Chinese Rival"). Cisco settled in July, 2004, after Huawei agreed to revise some of its products.

"A VISIONARY." These days, H-3C merits a closer look. In its most recent quarter, its revenue was up 69% from a year earlier, to $111 million. Huawei has been taking share from Cisco for years in China, prompting Cisco to link up with another Chinese telecom maker, ZTE, in November (see BW Online, 12/05/05, "Cisco Has a New China Partner"). "Claflin was a visionary," says Stuart O'Gorman, co-manager of the Henderson Global Technology Fund.

Shares of 3Com made up about 1.6% of O'Gorman's fund as of last Sept. 30. "The stock is the only way to get exposure to Huawei and the growth they have in the Chinese networking market," he says.

In October, Claflin made a move that could start attracting even more attention to the venture. He exercised an option allowing 3Com to add 2%t to its stake in H-3C for $28 million. If approved by the Chinese government, the purchase would give 3Com majority control and allow it to consolidate the venture's results on its balance sheet. Just how long it will take for Chinese authorities to approve the deal, which also has Huawei's backing, is unknown.

ROBUST SALES. 3Com's own sales of H-3C-made goods, like Ethernet switches that operate over power lines and gear for sending voice calls using Internet technology, quadrupled in the last quarter from a year ago. This has helped raise 3Com's overall gross margin to 40% compared with 34% a year earlier.

The other winning play for 3Com: its January, 2005, acquisition of TippingPoint Technologies, a maker of Internet firewalls and hacker-detection gear, for $430 million. In 3Com's last quarter, revenue of security products shot up sixfold, to $20 million.

Overall, sales were up 22%, to $184 million, vs, a year earlier. It was 3Com's best quarterly percentage gain, compared on an annual basis, in eight years. Revenue was up 4% from the previous quarter, the fourth consecutive sequential gain. 3Com's net loss declined to $10.7 million from $48.8 million in the same quarter a year ago.

"TOO DELUSIONAL"? Still, not everything is rosy at 3Com. The lower net loss in the last quarter was due in part to a one-time $24 million benefit from a foreign-tax dispute settlement. And it burned through almost $100 million of cash in the past six months, as revenues still aren't covering the cost of operations. Claflin says more "expense control" will be forthcoming as revenue grows over the next few quarters.

Skeptics also point to Claflin's statements last year that 3Com was taking aim at rival Cisco. Back in 1997, both companies had about $5 billion in revenue, but Cisco has grown to $25 billion while 3Com shrunk to under $1 billion. "It's still too delusional," says Philip Tasho, co-manager of ABN Amro/Tamro Small Cap Value Fund. Tasho would like to see 3Com focus on fewer niches. He dumped his fund's 3Com stake in the fourth quarter. Says Tasho: "I just don't know when profitability is going to come."

Fund managers who are buying 3Com mainly see it as a value play. Considering 3Com's possession of the equivalent of almost $2 a share of cash in its coffers and its stake in H-3C, the rest of the company is valued at almost nothing. That's in part because analysts at major Wall Street and independent research firms don't pay much attention to tiny 3Com after all its turmoil. That could change if Claflin's bets keep paying off.


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