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WIKI ANALYSIS| This company has recently been acquired or received a credible acquisition offer. |
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 2007, enterprise networking accounted for 98.8% of 3Com's total revenue and desktop, mobile, and server connectivity accounted for the remaining 1.2%. Geographically, 3Com generated nearly 54.5% of its revenue from the Asia/Pacific region, 21.5% from Europe, the Middle East, and Africa (EMEA) 18.4% from North America and the remaining 5.6% from Latin and South America during fiscal 2007.
Over the past few years, 3Com's revenue base has declined rapidly as its core network connectivity products, such as adapter cards, became obsolete. As a result, revenue has fallen from $1.5 billion in fiscal year 2002 to $800 million in fiscal year 2006. Driven by acquisitions, revenue rebounded to $1.3 billion in 2007 however the company burned through $360 million in cash and added $336 million in long-term debt in the process. 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 acquired the remaining 49% for $882 million. This represents a rich implied equity value of $1.8 billion. Huawei signed a non-compete agreement with 3Com for 18 months, meaning the company could compete directly by the end of 2008. Before this transaction, 3Com had a strong balance sheet, with no long-term debt and $956.1 million in cash and short-term investments as of March 2, 2007. As of November 2007, 3Com reported net long-term debt (cash less debt) of $131.1 million.
3Com faces intense competition in its core SMB (small or medium sized business) market from rivals like Netgear and D-link. Dell, known for dominating commodity information technology (IT) markets with its low-cost distribution, has entered the low-end data networking market. Cisco's purchase of Linksys has provided it with a low-end brand that it has used to launch SMB products. 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. Following the integration of 3Com and H3C Technologies, 3Com unveiled a unified sale and support organization for the Asia-Pacific region and reduced its total sales and marketing expenses by 3.5% through reorganization and head count reductions. However, it has failed to report positive earnings on a GAAP basis since fiscal 2001.
On a positive note, the acquisition of TippingPoint Technologies (TPTI) extends the company's portfolio to the rapidly growing network security market. The Intrusion Prevention Systems (IPS) market where TippingPoint competes is the fastest growing segment of the networking security market according to Gartner group, with an estimated compounded average growth rate (CAGR) of 25% from 2005 through 2009, and should help 3Com launch more competitive integrated products. For the first quarter of 2008, TippingPoint products and services generated nearly $25.5 million in revenues, up nearly 36% over year-ago period. TippingPoint continues to enhance its IPS offering, introducing enhanced performance and usability, as well as new protection for Supervisory Control and Data Acquisition (SCADA) protocols, VoIP, and online gaming. In order to improve its cash position, 3Com announced plans for an initial public offering of TippingPoint however this has been delayed due to volatility in the financial markets. 3Com intends to remain a majority TippingPoint shareholder following the IPO and plans to reduce its ownership over time in subsequent transactions, which could help the company to achieve a healthier cash balance, which we believe is a necessary cushion for the company to fund a turnaround.
3Com extended its existing managed security services through an alliance with Digital Defense, which will provide customers with additional tools for attaining compliance with government regulations, such as Sarbanes-Oxley, the Health Insurance Portability and Accountability Act (HIPAA). Additionally, it announced the availability of its fine-grained network access control (NAC) solution, which enables enterprises to enforce device and user policies to ensure endpoint and granular post access compliance. However, the market is already crowded, with big players like Cisco, Avaya, Nortel, and Siemens 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 55% of sales in fiscal 2007.
Recently, 3Com has agreed to be acquired by private equity firm Bain Capital partners for $2.2 billion in cash. As part of the transaction, affiliates of Huawei Technologies will acquire a minority interest in the company. 3Com expects to form new commercial and strategic alliances with the Chinese company, Huawei and expand in Asian markets where networking players like Cisco have a far bigger presence. On closing of the transaction, Bain Capital will control 83.5% of 3Com, while Shenzhen-based Huawei will own the remaining 16.5% stake at a cost of $363 million. Huawei can increase its equity by up to 5% based on certain performance criteria. By going private, we believe the company can ward-off competition from Cisco, and this will also relieve it from short-term financial expectations. Although we would typically upgrade the shares to hold on the buyout news, we believe there is a risk that the deal is not completed. Therefore, we would recommend 3Com holders take profits now rather than hold on for potentially another 10% fall in the stock's price. Most of our concerns regarding completion of the sale revolve around national security concerns given Huawei s connection with the Chinese government. There is concern that 3Com's networking technology could allow China to more readily tap into U.S. domestic conversations. In addition, a tighter credit market will make it more difficult for Bain Capital to raise the funds needed for the purchase. Although we do think there is a greater than 50% chance the deal closes, the downside risk outweighs the potential upside from current levels. If the Department of Defense blocks the sale on matters of security concern, this deal will not take place and the stock will continue to languish at under $4.00 and will continue to struggle with its weak balance sheet and unfavorable market demand.
Updates
In February 2008 it became evident that the joint filing by Bain Capital and Huawei Technologies to the Committee on Foreign Investment in the United States (CFIUS) would not be approved and the planned aquirors withdrew their application. The deal failed mainly due to concerns over giving a Chinese firm a stake in a company that provided network security to the U.S government, including the Pentagon.
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