3Com: Recent Acquisition Weakens Cash Position

| About: 3Com Corporation (COMS)

Headquartered in Marlborough, Massachusetts, 3Com Corporation (COMS) provides voice and data networking products, services, and solutions for commercial and public sector organizations of all sizes.

Its solutions range from network infrastructure products such as local-area networking [LAN] switches, hubs, and routers to connectivity products that enable computing devices to access computer networks, such as desktop network interface cards and PC cards.

The company also offers network management software and related services to install and integrate enterprise networks. For fiscal 2006, enterprise networking accounted for 95.0% of 3Com s total revenue and desktop, mobile, and server connectivity accounted for the remaining 5.0%.

Geographically, 3Com generated nearly 37.6% of its revenue from Europe, the Middle East, and Africa [EMEA]; 31.3% from North America; 22.1% from the Asia/Pacific region, and the remaining 9.0% from Latin and South America during fiscal 2006.

Over the past few years, 3Com's revenue base has declined rapidly as its core network connectivity products, such as adapter cards, have become obsolete. As a result, revenue has fallen from $1.5 billion in fiscal year 2002 to $795 million in fiscal year 2006. This trend is continuing with the decline in its 10/100 switching products, particularly in the U.S. market, and the commoditization of Layer 2 switches.

In an effort to grow into new markets, 3Com entered into a joint venture, initially taking a 49% ownership interest with Hong Kong-based Huawei Technologies [H-3C] in 2003. It has taken several years for Huawei products to gain traction and the JV still competes directly with Huawei in Japan, Hong Kong, and China. In 2006, 3Com purchased an additional 2% interest in the joint venture and recently announced its intention to purchase the remaining 49% for $882 million. This represents a rich implied equity value of $1.8 billion.

Though 3Com has a strong balance sheet, with no long-term debt and $956.1 million in cash and short-term investments as of March 2, 2007, this transaction will increase long-term debt by $430 million through a secured financing from its international banking partner. The remaining will be funded by the available cash balance, which is likely to leave the company with a slight negative cash balance after closing. This deal will also weaken the JV without the support of its partner and we believe this is a signal that Huawei wants to go alone in the U.S. market rather than retreat.

Huawei will sign a non-compete agreement with 3Com for 18 months, meaning the company could compete directly in 2008. 3Com faces intense competition in its core SMB (small or medium sized business) market from rivals like Netgear and D-link. Dell (NASDAQ:DELL), known for dominating commodity information technology [IT] markets with its low-cost distribution, has entered the low-end data networking market.

Although Cisco (NASDAQ:CSCO) has not yet competed aggressively in the SMB market, its purchase of home networking provider Linksys provides it with a low-end brand that it can use to launch SMB products. Cisco's launch of Linksys One, a hosted bundle of services, offering data and IP (Internet Protocol) telephony for businesses with less than 100 employees, should reduce IT costs for smaller companies, and will likely exert significant pressure on COMS market. In addition, SonicWALL has been able to gain ground in the SMB market with new offerings.

Huawei may also be a direct competitor, with its entry in the international markets, meaning 3Com would lose its competitive advantage as the sole provider of Huawei products worldwide. Most of 3Com's competitors have greater resources and are currently profitable. We do not believe that 3Com holds a competitive advantage over its competitors. In addition, the company is exposed to considerable customer concentration risks, with Ingram Micro and Tech Data accounting for nearly 19% and 11% of fiscal 2006 revenue, respectively.

While 3Com has taken steps to realign its reseller structure to support entry into the enterprise networking market, this has yet to show meaningful results. Though results have shown a rebound in the Americas, the company still faces significant execution challenges ahead as seen in the third quarter that recorded a 2.9% sequential drop in revenues. Moreover, the company must invest heavily in sales and marketing to gain traction with new products. In addition, weakness in EMEA could be part of a developing trend as other IT companies have struggled in the region.

On a positive note, the acquisition of TippingPoint Technologies [TPTI] extends the company's portfolio to the rapidly growing network security market. TippingPoint was positioned by Gartner in the leaders quadrant in the '2H06 Network Intrusion Prevention Systems [IPS] Appliances Magic Quadrant' report. IPS is the fastest growing segment of the networking security market with an estimated (by Infonetics Research, an industry analyst firm) compounded average growth rate [CAGR] of 25% from 2005 through 2009, and should help 3Com launch more competitive integrated products.

However, the market is already crowded, with big players like Cisco, Avaya (NYSE:AV), Nortel (NT), and Siemens (SI) vying for space, resulting in intense pricing pressure. Moreover, 3Com still needs to do a better job of resizing its cost structure as operating expenses have accounted for more than 60% of sales in fiscal 2006. Although management has taken a number of measures to restructure the company (operating expenses accounted for 50.2% of sales during the nine month period ended February 2007) for a lower run rate and achieve break-even operating results in fiscal 2007, it has yet to achieve a profitable balance and the company continues to burn cash.

In addition, these actions are expected to record restructuring charges of approximately $10 to $13 million in fiscal 2007. Moreover, rising receivable days are continuously impacting its liquidity. With the recent announcement of 3Com s buying the remaining interest in the joint venture of H-3C, we do not expect the company to achieve profitability (on GAAP numbers) in the near term. Furthermore, we are also concerned with the recent changes in management level. In light of the above developments, we reiterate our Sell recommendation on 3Com.

INDUSTRY OUTLOOK - NEUTRAL
The outlook for the Computer Hardware industry is Neutral relative to the S&P 500. While we had been cautious on the sector pending implementation of Financial Accounting Standard No. 123R, also known as FASB 123R, requiring companies to expense employee stock options. Companies with a June fiscal year-end began to report results including the impact of options in the September 2005 quarter.

Thus far, the impact of reduced earnings on a Generally Accepted Accounting Principles [GAAP] basis has appeared to be minimal, reassuring us that once all companies begin complying with FASB 123R during 2006 the impact on stock prices will be minimal. Although enterprise spending has rebounded modestly during 2004 and 2005, we have yet to see a significant acceleration in spending on Information Technology by large enterprise customers.

We believe that while Chief Information Officers [CIOs] have increased spending in order to keep up with requirements of the business, most are still in the cost savings mode that has existed over the past five years. As confidence in the economy increases, we believe that this mentality will gradually shift from one of cost savings to increasing efficiencies. As this mentality changes, we expect to see increased spending on new technologies, such as Voice over Internet Protocol [VoIP], and an overall acceleration in growth industry wide.

Offsetting our optimism on the future of enterprise spending are concerns about consumer spending. Rising interest rates and a potentially slowing housing market have taken a toll on consumer spending of technology products, leading to disappointing results from companies with consumer exposure. We therefore look to companies with new technologies and enterprise exposure for out-performance in 2006, while other industry participants languish in a still lukewarm environment.

INDUSTRY POSITION

3Com Corporation competes in the networking infrastructure market, providing a broad portfolio of secured, converged voice, and data networking products to small, medium, and large size organizations, as well as to carrier customers through the H-3C venture.

The market in which 3Com competes is competitive, fragmented, and rapidly changing. Its principal competitors include Avaya Inc., Cisco Systems, Inc., D-Link Systems, Inc., Enterasys Networks, Inc., Extreme Networks, Inc., F5 Networks, Inc., Foundry Networks, Inc., Hewlett-Packard Company, Internet Security Systems, Inc., Juniper Networks, Inc, McAfee, Inc., Alcatel, Mitel Networks Corporation, NETGEAR, Inc., and Nortel Networks Corporation. In addition, H-3C also competes with key regional competitors such as Allied Telsis, Inc. (formerly Allied Telesyn), Buffalo Inc., Digital China, Harbour Networks, Hitachi and ZTE Corporation.

Dell, known for dominating commodity information technology markets with its low-cost distribution, has entered the low-end data networking market. In addition, SonicWALL has been able to gain ground in the SMB market with new offerings. Though VoIP promises significant growth opportunities, the market is already crowded with big players like Cisco, Avaya, Nortel, and Siemens vying for space, resulting in intense pricing pressure. Most of 3Coms competitors have greater resources and are currently profitable. We do not believe that 3Com holds a competitive advantage over its competitors.

RECENT NEWS
Earnings: On March 22, 2007, 3Com Corporation announced results for the third quarter of fiscal year 2007. Results for the quarter were mixed with revenues coming in below our estimate of $335 million, and EPS coming in four cents better than our estimate for a loss of $0.02 including stock based compensation of $0.01. Including a full three months result from its majority-owned joint-venture Huawei-3Com, GAAP revenue for the quarter was $323.4 million, an increase of 82.2% from $177.6 million in the year-ago quarter. Assuming consolidation from the beginning of the period, revenue on a pro forma basis increased 6.0% year-over-year (y-o-y).

The overall growth is largely attributed to the consolidation of H-3C revenue, which was partly offset by decreased revenues in the SCN segment. Product-wise, networking contributed 80.1% (up 116.9% y-o-y) to total GAAP revenue, security 9.5% (up 20.0% y-o-y), voice 5.8% (up 49.6% y-o-y), services 3.0% (up 23.2% y-o-y), and connectivity products 1.6% (down 57.9% y-o-y). Growth in the Asia Pacific Rim (up 725.5% y-o-y) offset the decline in EMEA (down 12.3% y-o-y), Latin and South America (down 9.2% y-o-y), and North America (down 3.8% y-o-y). Gross margin of 47.4% was up 660 basis points y-o-y.

Excluding amortization of intangibles, in-process research and development, and restructuring charges, operating margin was 1.6%. This was an improvement of 2,370 basis points y-o-y owing to reduced operating loss in the SCN segment. GAAP net loss for the quarter was $4.8 million or $0.01 per share versus net loss of $32.8 million or $0.08 per share in the year-ago quarter.

Excluding one-time line items but including stock-based compensation expense, EPS for the quarter was $0.02. 3Com ended the quarter with $956.1 million in cash, cash equivalents, and short-term investments, up $87.6 million from the previous quarter. The net increase was driven by positive cash from operations of $100 million. Long-term obligation and deferred revenue for the quarter was $2.3 million, down $0.4 million from the previous quarter.

Also, during the quarter, the company acquired certain assets from Roving Planet to support its Network Access Control [NAC] strategy. Buyout of the H-3C JV On March 22, 2007, 3Com announced the receipt of final approval from the People's Republic of China for 3Com to acquire Huawei Technologies' 49% stake in H3C for $882 million. 3Com, which won the right to acquire the remaining stake in H3C through a bidding process that ended on November 28, 2006, anticipates the deal will close on or about March 29, 2007.

To fund the transaction and related expenses, 3Com intends to use approximately $470 million of cash on hand in its Secure, Converged Networking, or SCN, segment and approximately $430 million from a senior secured bank loan (that will mature on September 28, 2012) at its H3C segment. Product updates On February 5, 2007, TippingPoint/3Com announced the availability of its fine-grained network access control [NAC] solution. TippingPoint NAC enables enterprises to enforce device and user policies to ensure endpoint compliance and granular post access compliance.

On January 22, 2007, TippingPoint/3Com announced that it is extending its existing managed security services through an alliance with Digital Defense. This alliance will provide customers with additional tools for attaining compliance with government regulations, such as Sarbanes-Oxley, the Health Insurance Portability and Accountability Act [HIPAA]. The offering includes project-based or scheduled subscription-based vulnerability assessments, penetration testing, and workflow vulnerability management through an alliance with Digital Defense. Customers can outsource these services to TippingPoint through private label integration with Digital Defense.

VALUATION
Although 3Com is facing a number of fundamental challenges, its valuation is currently supported by a strong net cash position of $2.42 per share. However, this will be lost when the company completes the purchase of H-3C JV with new debt and available cash on its balance sheet. This deal has increased both execution and financing risk. Although we are optimistic on the success at TippingPoint along with improved cost cutting efforts, this still has a long way to go as its legacy business remains a drag on results. Hence, we reiterate our Sell recommendation on the shares of 3Com with a six-month target price of $3.50, which is based on a P/S multiple of approximately 1.0x our 2008 revenue estimate of $3.35 per share.

RISKS
3Com has been facing a declining revenue base, and operating expenses are running nearly 50% of sales during the nine month period ended February 2007, indicating that the company is having trouble adjusting its operating model to its lower revenue run-rate. Competition is intense and most of its competitors have greater resources and are currently profitable. The company has been facing weakness in the EMEA region as well as in the Americas, of late. The company is exposed to considerable customer concentration risks, with Ingram Micro and Tech Data accounting for nearly 19% and 11% of fiscal 2006 revenue, respectively. The recent announcement of 3Com buying the joint venture H-3C is expected to reduce the amount of net cash. This would, thus, be challenging for 3Com over the longer term as the deal has increased execution as well as financial risk.

INSIDER TRADING AND OWNERSHIP

Institutions hold about 67.2% of total shares outstanding. The top four institutional holders are Barclays Global Investors UK Holdings Ltd (5.1%), Brandes Investment Partners L.P. (4.5%), Wells Fargo & Company (3.9%), and Legg Mason, Inc. (3.8%). Net institutional sales were 19.8% or 44,188,500 shares in the previous quarter. Insiders control roughly 2.4% of total shares outstanding. There were no significant transactions in the last six months. The short interest ratio is around 3 days, which we believe is neutral.

COMS 1-yr chart: