Fight not over for 3Com

The fight over a standard for its high-speed modems may have been resolved, but 3Com has yet to remedy many other problems.

Dawn Kawamoto Former Staff writer, CNET News
Dawn Kawamoto covered enterprise security and financial news relating to technology for CNET News.
Dawn Kawamoto
5 min read
The fight over a standard for its high-speed modems may have been resolved, but 3Com (COMS) has yet to remedy many other problems that plague the company.

Channel inventories still need to be reduced, new competition from Intel and Cisco Systems is heating up for retailers and resellers, key products like its adapter cards and modems increasingly are becoming commodity items, and economic woes coming out of Asia continue to loom.

On the financial end, 3Com's performance has yet to recover from the hit it took last year from a much-larger-than-expected modem inventory in its channels after its acquisition of US Robotics. The company reported a second-quarter profit of $15.1 million for the period ending November 28, down substantially from $105.6 million a year ago. Revenues, however, rose to $1.2 billion for the quarter, up from $820.3 million the previous year. The networking company is expected to post its third-quarter results in March.

On Wall Street, 3Com's stock is far from recovering from its nose dive early last year, when it fell from a trading price of around 73 in January to 40 the next month, as competitor Intel slashed prices on its adapter cards or network interface cards (NICs). The stock fought back to climb to around 60 that summer, only to stumble steeply once again, to around 30, in the October-November period, as fears mounted that its modem inventories were far larger than earlier expected and that the company would have to halt sales into the channel. Since that winter period, the stock has been virtually comatose, closing yesterday at 33-3/4, up 1-1/8 over the previous day's close (See related story).

"I don't believe [their stock] will outperform the market until they get their channel inventory taken care of and get sell-through on new products," said Michael Cristinziano, an analyst with Gerard Klauer Mattison.

Representatives of 3Com were not available to comment.

Indeed, a number of analysts cite channel inventory as a major challenge for the company to overcome. "They had problems with their channels even before the US Robotics merger," said Craig Johnson, a principal analyst with Dataquest. "They have a tendency not to know what is coming out of the other end of the channel [after selling into the channel]."

In December, 3Com set lower targets of how long it wanted inventory sitting in its channel. The move is designed to lower its exposure from letting products become obsolete while in the channel and to reduce the amount of price-protection money it has to shell out to resellers, who could find that they're left holding products in the channel should 3Com later initiate a price cut on those products. 3Com said these changes should allow it to adjust more quickly to shifts in market demand.

As part of its inventory reduction plan, 3Com only wants six to eight weeks of its modem inventory in its channel, down from its old target of eight to 12 weeks. Cristinziano estimates that, as of late November, the company had a ten-week inventory. Analysts, meanwhile, remain on the fence as to whether the new 56-kpbs standard will help propel sluggish sales of 3Com's x2 56-kpbs modems.

3Com's systems business also appears to still need further ratcheting down in order to hit the new target of five to seven weeks, compared with the old target of eight to 12 weeks. The company currently appears to have a 9-week inventory, Cristinziano said.

However, the company has met its new target of four to six weeks for its NICs and local area network products--which it reduced from six to 10 weeks. Last quarter, 3Com was able to get its NICs and LAN inventory down to 5 weeks.

"These areas all have improved in the last quarter and are expected to improve this quarter, but it still has some improvement to go," Cristinziano said.

3Com officials briefed analysts recently and indicated that its inventory targets may not be achieved in the current quarter, according to a report by Peter Rubicam, an analyst with Credit Suisse First Boston. Some analysts suspect that missed targets may bleed into the next quarter as well.

The company also faces increased competition from Cisco and Intel, which are trying to lure away wholesale distributors, retailers, and small resellers in their two-tier channels, where 3Com has been particularly strong. (Intel is an investor in CNET: The Computer Network.)

Cisco is looking to branch out from what largely has been a direct-sales approach to serving its new mid-tier Soho program, while Intel is stepping into the low-end systems market and as a result has found itself needing to rely more on the modem channel.

"Cisco is going into the channel and trying to glean the cream of the crop among resellers," Johnson said. "Bay is in the process of rejiggering its channel program to defend against Cisco."

Roughly half of 3Com's $5.6 billion in revenues in fiscal 1997 came from its core networking products, while the other half was derived from NICs, modems, and its Palm Pilot. Both areas increasingly are becoming a commodity business, Johnson said.

3Com's Palm Pilot has high margins, but even this quickly is becoming a commodity product as competitors like Microsoft introduce products, he added. The areas where they currently are the strongest--NICs; modems; and low-end systems for small and home offices that include stackable hubs, switches, and remote devices--increasingly are becoming a commodity market.

Although analysts foresee the increase in 3Com's revenues being represented by products separated from competitors laregly by price, they note it may not be a bad thing if the company is able to achieve the financial performance of companies like Dell Computer, which makes up for smaller profit margins by volume sales.

The question of whether 3Com will be able to generate volume sales as competitors step into its turf has left a number of analysts hedging their bets.

Cristinziano and Rubicam have a "hold" recommendation on the stock, as do ten other analysts out of the 24 that have issued recommendations on the company. Three analysts have a "weak buy" recommendation, and nine have a "strong buy," said Rob Gowen, a spokesman for First Call.

Analysts' consensus earnings estimate for 3Com's third quarter is 14 cents a share, Gowen said. He noted that one analyst lowered his estimate yesterday, to 13 cents from 17 cents.

Additionally, Asia continues to create uncertainity for the company, given that it derives 10 percent to 15 percent of its total revenues from the region. Sales there have fallen to 9 percent of total revenues in the second quarter, as what was once a 50 percent year-over-year growth rate stalled, Rubicam noted in his report.

"Because 3Com is a leader in the low-end LAN, that positions them well for being taken over. For example, Lucent is the biggest component supplier to 3Com, and Lucent has said it is more likely to acquire a LAN company than develop it," Cristinziano said. "And this stock may not get any cheaper."