3Com suffers with a seasonal sales flu

3Com warned yesterday that its third quarter earnings would come in well below market expectations, citing seasonal effects and hints of an industry-wide slowdown.

The company's stock dipped more than 10 percent in trading this morning.

The computer networking company said sales for the quarter ending February 26 are expected to be between $1.41 billion and $1.415 billion. Earnings per share for the period are now expected to come in at 23 cents, far below analysts' consensus estimates of 36 cents per share, according to First Call.

Company executives said they had expected some slowdown in the post-Christmas season. But demand for the company's products has also been weaker than expected in the U.S. and Latin America, and among PC sellers, they said.

"This is not the quarter we expected to have, but it is still a significant improvement over a year ago," said Bruce Claflin, the company's chief operating officer. "What is unknown is to what degree there is an industry slowdown operating here."

Claflin said there was as yet no evidence that the company was losing market share to Cisco Systems, which has recently strengthened its competition in some of 3Com's most profitable markets.

While the news did undercut Wall Street's consensus estimates, the financial community was not taken entirely by surprise.

The company's stock has been sliding progressively south for the last month. Even before the warning, the company's stock fell to 27 by the end of the trading day yesterday--after reaching a 52-week high of more than 51 in January.

"We've been worried about their strategy," said Moors & Cabot analyst Greg McClenon. "We've known for a while that their client access unit has been under pricing pressure."

Today, Morgan Stanley, BT Alex Brown, and CS First Boston downgraded the company's stock, citing market weakness.

The news also comes at a bad time for company management, which had only recently regained solid market footing after its 1997 merger with US Robotics.

"Problems that develop in a seasonally weak quarter get magnified. And in the near term, management's credibility has been damaged," said Merrill Lynch analyst Joseph Bellace. "They were in the mode of re-establishing credibility. And it's gotten short-circuited."

Old markets for new
Executives said today that they would shift the company's focus away from slow-growth areas, such as analog modems and network cards.

"We have not decided to exit any part of our business," said Eric Benhamou in a conference call. "But we have made plans to reduce investment in some product lines." He specifically cited analog modems, which still dominate the consumer market but are slowly being replaced by broadband services.

Claflin later noted that close to 45 percent of the company's revenues still come from this consumer division, which as a whole posts "very slow growth," he said.

In response, the company will be shifting more investments into six areas that still mark relatively small portions of its business, Benhamou said.

These areas will include handheld computers--such as the company's successful PalmPilot line--along with IP telephony products, broadband access devices such as cable and DSL modems, home networking systems, wireless products, and storage area networks.

The PalmPilot division is the only one of these areas that is now bringing in significant revenue, Claflin said. That product also experienced some seasonal slowdown this quarter, but the decline was entirely in line with the company's expectations, he added.

Storm clouds on horizon?
The earnings warning and last month's stock drop have raised concerns that the company could be a takeover target for a competitor like Siemens.

But even if the company does stay independent, analysts aren't convinced it's entirely on the right track.

"3Com is in a tough position. It's business is rapidly changing," McClenan said. "I don't know if those [new] areas make up a complete business model for a big company like that."

Meanwhile, news of lower-then-expected earnings from distributors and PC makers like Dell and Compaq might translate into a rocky period extending beyond the current slow season.

"It's very clear to us that there is some moderation in the industry's growth," Claflin said. He stopped short of predicting that a slowdown would affect the company's next quarter, however. "It's impossible to say how long this will last," he said.

News.com's Wylie Wong contributed to this report.