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3Com, U.S. Robotics face trouble

3Com and U.S. Robotics are newlyweds, but the lack of a modem standard, international financial turmoil, and a shareholder lawsuit are putting a damper on the honeymoon.

3Com (COMS) and U.S. Robotics are newlyweds, but the lack of a modem standard, international financial turmoil, and a pending shareholder lawsuit announced today have put a damper on the honeymoon.

The newly merged company already had been facing problems stemming from financial tumult in Asian markets and the ongoing industry battle to agree upon a standard for 56-kbps modems. Now, a shareholder lawsuit taking issue with the company's temporary discontinuation of shipments is threatening to take even more oomph out of the revenue boost that USR's modem business was expected to give 3Com.

The conspiring of events adds to the trouble 3Com has experienced as a result of decelerating growth in demand for networking products, which led to the company's decision to ratchet down shipments to the channel in an attempt to move to a more "just-in-time" shipment strategy.

3Com shares, meanwhile, have had a rough ride since the $8.5 billion stock-swap merger deal was announced February 27. The company's shares, which closed at 39 the day before the merger announcement, fell as low as 24 per share on April 22. The deal closed in June, and the stock later went on to rebound to a high of 59-3/4 on July 16.

But since that summer peak, the stock has sunk to below the level at which it traded when the merger first was announced. 3Com closed at 34-15/16 today, down 3/8.

Shareholders expressed their fury regarding the news by filing a lawsuit against the company. They allege that 3Com issued false and misleading statements about the demand for and acceptance of its modems, when U.S. Robotics, in essence, stopped shipping them in April and did not resume shipment because of excessive inventory.

The lawsuit was filed in U.S. District Court in the Northern District of Illinois, and seeks a class-action claim for the period between May 19 and November 6. 3Com officials declined to comment on the action.

However, in an earlier interview today, Janice Roberts, 3Com's senior vice president of global marketing and business development, said: "The modem business is still strong, but the bigger market opportunity has not happened because of the standard [delay] ."

Although Roberts said a standard is expected in January, the hopes of the modem industry that a standard will materialize were dashed when a preliminary draft of the standard failed to be approved last September. Modem sales account for roughly a third of 3Com's sales, analysts have said.

In an attempt to expand its revenue options, 3Com's modem business since has been developing other products, such as ADSL and cable modem technology.

Despite the sluggish sales of modems, Roberts said 3Com is not planning on selling any parts of the former U.S. Robotics business. One area that had been speculated as a likely spin-off candidate was U.S. Robotic's PalmPilot, a handheld pocket organizer. The company has previously said it is one of their best-selling products and in a move to spur sales further, cut prices by 8 percent on its Professional Edition and 17 percent on its Personal Edition last October.

Andy Schopick, an analyst with Nutmeg Securities, said 3Com and U.S. Robotics have some overlap in the modem business, but because modems are just a portion of 3Com's business, the merger does not have much relevancy to the company's excess inventory issues.

This is evidenced by the fact that the company recently had to adjust its inventories across all product lines, not just modems, he explained.

The company said it has reduced the inventory level at its channel partners and has revised its inventory practices across a number of levels of its business--including its partners, business units, and worldwide divisions--in order to aid predictability and streamline sales. Additionally, 3Com noted that it expects the reduced inventory to cut into profits for the upcoming quarter, the results of which will be released December 18.

The company's stock lost nearly 10 percent in morning trading, with more than three times the average daily volume, or 29.8 million shares, trading hands. The stock regained some of its early losses and ended the day off slightly.

The networking company, which announced that it would trim its inventory levels in the channels by three to five weeks, also was dealt a handful of downgrades and revised estimates in response to the changes.

BT Alex. Brown and Donaldson Lufkin and Jenrette downgraded the stock to "market performer" from "buy"; Gerard Klauer Mattison and Hambrecht & Quist downgraded it to "hold" from "buy." Other firms cut earnings estimates. Gruntal & Company cut its earnings estimates, and Bear Stearns maintained its "buy" rating on 3Com, but lowered its earnings estimates for the company.

BancAmerica Robertson Stephens, however, upgraded the networking company to "buy" from "hold." In a research report released today, analyst Paul Johnson applauded the company's decision to move beyond the inventory issue.

But the round of downgrades and revised estimates stemmed from uncertainties surrounding the impact of more inventory cuts, delays in a 56-kbps modem standard, the Asian economic situation, and pricing issues for lower-end systems.

Schopick suggested that the company's most recent results probably overstated growth, and said that they also suggest that "the existing level of user demand does not justify maintaining this level of channel inventory."

3Com's Roberts said that the company has not inflated its sales number or inventory numbers. "Sales have been strong but not strong enough to keep our inventory as high as it was," she said.

The networking industry has fallen from its peak growth in 1995 and 1996, when growth was in the 30 percent to 50 percent range. A slowdown from those peaks has hit margins as the industry matures. Analysts say expenses need to be trimmed back in order to accommodate the slowdown.

For example, 3Com's Roberts said, because the industry is more mature now, there no longer will be the huge growth that was seen in the past. The key impact, she said, is the Asia market. "It has gone from 50 percent growth to zero, and that is impacting the business," she said.

Although the inventory decision will negatively affect earnings and cashflows during the second and third quarters, "it does not have a material effect on the overall economic worth of the company," said BankAmerica's Johnson.