3Com struggles amid industry boom
Following 3Com's latest Wall Street disappointment, a growing number of analysts, investors and company insiders question the firm's strategy and its leadership.
The Santa Clara, Calif.-based data networking firm yesterday said revenue growth slowed in the second quarter. Additionally, the company warned that third-quarter profits would be comparable to last year's results and less than analysts' expectations.
As a result, 3Com stock dropped as much as 17 percent early today while analysts cut earnings estimates for the third quarter and the fiscal year. Shares recovered slightly to end the day down more than 8 percent.
Wall Street now expects the company to earn 26 cents a share, down from a previous consensus of 32 cents, according to First Call. For the year, 3Com is now expected to earn $1.26 a share, compared with previous estimates of $1.35.
3Com chief executive Eric Benhamou has led the networking firm through a number of financial and strategic crises over the past two years, yet has faced industry criticism throughout. Yesterday's news will no doubt put even more heat on Benhamou and his beleaguered company.
After the latest announcement, critics say it is clear that the success of its Palm Computing subsidiary has obscured greater underlying problems at the networking firm. Once Palm is spun off as a separate company next year, 3Com will be left with a stagnating networking business that has recently shown few signs of significant growth. As an example, the company's sales of networking systems products--a vital cog in the company's strategy--were down 12 percent sequentially for the second quarter.
"Their Palm business has brought the overall stock up, but it's no secret that 3Com has some underlying problems with their core networking business," Cahners In-Stat Group analyst Michael Wolf said.
"The majority of where they've held market share has been commodity segments, and that continues to be the case. They are continuing to experience problems transitioning to more profitable areas," he added.
For 3Com investors and analysts, the current turmoil is the sum total of two years of repeated disappointments. The company has been plagued with a lackluster stock price, stagnant revenue growth and miscalculated strategic moves that have yet to improve the company's fortunes.
By contrast, heavyweight competitors such as Cisco Systems and Nortel Networks have each seen their share price soar as telecommunications carriers, Internet service providers (ISPs), and corporations line up to buy their equipment.
Yet executives remain optimistic in the face of increasing competition and Wall Street criticism. Bruce Claflin, hired as president and operating chief last year to handle the daily operations of the networking firm, said 3Com is now on the right track.
"The strategy of the company is becoming more focused and clear," Claflin said.
But in a year noted for the tremendous gain in technology issues, 3Com stock is ending up almost where it began.
Shares of the networking company fell in February and languished for most of the year. The stock has perked up in recent months, however, largely as a result of its plans to spin off its popular Palm unit, Hambrecht & Quist equities analyst Erik Suppiger said.
For some industry insiders and analysts, the responsibility for the company's malaise lies with Benhamou, who has led the company since 1990.
"The company's not performing," one former 3Com executive said. "In this incredible growth market, [Benhamou] had a vision…that went wrong."
Sanford C. Bernstein analyst Paul Sagawa said Benhamou takes too long to ponder strategic decisions when quick, decisive action is needed.
"Eric is very intellectual and treats things that way," Sagawa said. "But his personal style is probably part of the reason they've puzzled over making sense of their existing businesses, as opposed to stating a focused vision and striding toward it. The company is clearly crying for a much more articulated direction and focus. Eric's never been 'Mr. Vision.' He needs to step up to the plate."
3Com declined CNET News.com's request for an interview with Benhamou unless all sources were named, according to Brad Leone, a company spokesman. CNET News.com did not agree to the terms, given assurances made to sources.
3Com directors this year made sure that Benhamou's compensation was more closely tied with the company's stock performance. The CEO received 273,425 option grants this year--more than twice the number he received last year. Benhamou's base salary grew 1 percent to $750,000 and no cash bonus was given, according to the company's filings with regulators.
"Benhamou's compensation package was designed to be strongly aligned with the interests of stockholders by making his short-term cash incentives and long-term equity incentives directly tied to achieving specific targets," the proxy stated.
In recent years, 3Com's stock has lagged behind the Standard & Poor's 500 Index and the S&P Technology Sector Index.
For example, a $100 investment in 3Com back on May 31, 1994, would have been worth $232 five years later. That same $100 would be worth $316 had it been invested in the S&P 500, or $561 had it been invested in the S&P Technology Sector. If a similar investment was made in Cisco on July 31, 1994, it would be worth $2,662 five years later.
Start-ups in the networking space have eclipsed 3Com in market share. Foundry Networks, a company that went public this year, makes similar networking technology to 3Com. Yet Foundry has a market capitalization of $18.1 billion, compared with 3Com's $16.5 billion.
"The board is concerned with the stock price and thinks the company is undervalued," said a source familiar with the discussions of 3Com's directors.
Faced with an undervalued stock, over the past few years 3Com has been the subject of buyout rumors. Sweden's Ericsson and German networking firm Siemens are among the companies rumored to be interested.
"Eric's not opposed to a buyout, but he doesn't see it as a salvation. If someone approaches the company with an unsolicited offer at a premium [to where the stock is currently trading], the directors will take a look at it," said a source familiar with the company's board.
Yet despite many concerns, directors are confident in Benhamou's leadership, a source said.
"[The directors] have a lot of confidence in Eric…The company's problem isn't Eric. No one thought the modem market would crater, and the US Robotics acquisition had a lot more problems than anyone thought there would be."
The source added that the appointment of Claflin shouldn't be construed as an effort to push Benhamou aside.
"Bruce is a good counterpart to Eric. Bruce is driving the sales and operations of the business and Eric provides the vision and strategy. It's a good fit that blends very well," said the source.
Although Claflin was hired to handle the daily operations, analysts note the company stumbled in the second quarter, raising questions about Claflin's effectiveness. "They've been plagued with some product development problems," said Hambrecht & Quist's Suppiger.During an interview following 3Com's latest earnings, Claflin said the company is hopeful and its strategy is ready to pay dividends.
"Over the last year and year and a half, we have refined our strategy, got more focused and have a simple, compelling unified strategy going forward," Claflin said.
Claflin said he believes the company's focus on emerging markets, such as home and wireless networking, Internet telephony and high-speed modems, will boost revenue in the coming year.
"They are our future. It's growing extremely rapidly now," Claflin said.
Analysts and former executives say 3Com's recent troubles began as early as 1997. First, the company entered a price war with Intel over network adapter cards, a key 3Com product. That battle resulted in 3Com taking a hit to its earnings, while investors bailed out of the company's stock, sending the share price down more than half in a matter of weeks.
And following 3Com's $6.6 billion acquisition of modem maker US Robotics (USR), the firm found itself with an unexpectedly large inventory of analog modems that temporarily forced it to discontinue sales. In general, the market for analog modems has slowed.
"Benhamou did a good job building the company with acquisitions,
| By the numbers Revenue for the past three years has largely been stagnant, while profit growth has slowed. | ||
| Year | Revenue | Net income (loss) |
| 1999 | $5.8 billion | $403.9 million |
| 1998 | $5.4 billion | $30.2 million* |
| 1997 | $5.6 billion | $500.5 million |
| 1996 | $4.3 billion | $347.9 million |
| 1995 | $2.5 billion | $210.5 million |
| 1994 | $1 billion | ($11.9 million) |
| 1993 | $723.2 million | $45 million |
| 1992 | $423.8 million | $8 million |
| 1991 | $413.2 million | ($23.8 million) |
| 1990 | $430.3 million | $23.2 million |
|
* Includes $253.7 million charge for US Robotics acquisition
Source: 3Com annual reports | ||
Benhamou has launched a number of different strategies to get the company back on track, but none has proved to be sustainable.
First the company attacked Cisco by pushing sales of high-end equipment to telecommunications carriers. When that effort failed, 3Com focused on its sales to businesses.
"They tried to be in the service provider market and move products upstream, where Cisco was, and down to the consumer level. And they were stretching themselves too thin," Armacost said.
Earlier this year, 3Com briefly announced it would enter the market for storage area networks, but then quickly backpedaled.
Last May, Benhamou declared the popular Palm handheld device--which 3Com inherited with the US Robotics acquisition and which has served as an unexpected growth engine for the company--as central to 3Com's overall strategy.
But this fall, Benhamou switched gears and said the company will spin off the Palm Computing unit so 3Com can concentrate on its networking roots. Investors have warmly received the spin-off plans, as shares have gained in the past few months.
The number of twists and turns has left industry analysts as well as some former 3Com employees baffled.
"[Benhamou's] scrambling. It's a company that doesn't have a clear sense of who it is, what market it's in, and who its customers are," a former 3Com executive said. "He had a great first few years, but he has been floundering the last few."
And that also had translated into confusion among analysts on Wall Street.
"They became less articulate about their strategy to the Street. They hid from the investment community when things started going wrong and they started losing investor confidence," Armacost said.
But many believe the latest plans for a Palm spin-off and the company's renewed focus on networking are smart moves.
Benhamou, as early as 1998, advocated spinning off the Palm Computing unit. But when Palm founder Jeff Hawkins, along with Donna Dubinsky, Palm Computing vice president and general manager, left the company those plans were put on hold, said the source close to the board.
"The feeling was that the timing wasn't right in order to maximize shareholder value for 3Com shareholders," the source said.
Despite the travails of the past two years, former executives say Benhamou has had a significant impact on 3Com. For example, revenue reached $5.8 billion in 1999, up from $430 million in 1990.
Benhamou joined 3Com in 1987 as vice president of products, and then in 1990 took the helm of the company that was "near death," said Bob Finocchio, the former 3Com president who worked with Benhamou for nearly a decade before leaving in 1997 to become the head of database software firm Informix.
"It was a big jump for him and he was totally untested, having previously been an engineering manager at Bridge," Finocchio said. "But there was total support for him throughout the company for his vision and desire."
The recent turmoil isn't the first time Benhamou has seen problems at 3Com. The firm at one time had a division that built network operating systems and servers, but wasn't profitable. Benhamou killed the division so the company could focus on networking, a technology he believed to be the future.
"He put a bullet in that whole business," said another former 3Com executive who worked in the network operating system and server business. "We were bleeding money, spending too much on development and not gaining market share."
The move saved the company, the former executive said. "That got 3Com started on the right path. The share price was in the tank. Profitability and growth had flattened out. And Eric believed the next big thing was networking, not a network computer."
Nonetheless, opinions differ on Benhamou's ability to provide the company with great vision.
"He's really analytical. He's an engineer. He's not a visionary," a former executive said. "Whenever I had meetings, he drilled down to the product detail. He understood product things. Because of that background, he's not someone who got people to rally behind him and feel like he understands what the business was--and going with it."
But Finocchio casts Benhamou in a different light.
"He was born to be a CEO. He has a natural talent to lead people, get them excited, has great vision, and the guts to make tough decisions," he said.
"My impression of this guy is that through the ups and downs of this company, he remains unflappable," Dataquest analyst John Armstrong said. "It's been to his credit that least outwardly, he has maintained the loyalty of his employees and staff."