15 Companies Management Can’t Fix: 3COM (COMS)

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Even with the hint of decent news on the horizon, 3COM (COMS-NASDAQ) finds itself in a precarious spot.  The company virtually leveraged its entire cash balance to buy the remaining half of the H3C joint venture with Huawei in China so it could get 100% of the joint venture that sells the ‘poor-man’s Cisco router.’  This was one of the only good things that has happened to the company, but it came at a huge price.  To fund the purchase price it secured financing from its international banking partner for up to $500 million in Hong Kong-based senior secured bank debt. The remainder of the payment will come from the cash and short-term investments on 3Com’s balance sheet.  The biggest problem with H3C is that it will have Huawei free to compete against it in what looked to be too fast of a non-compete expiration.  Huawei also has the ability to secure competing relationships faster because of its inroads in China.  Most likely that partnership is already spoken for and just waiting for the expiration date of the non-compete agreement.

3COM is still embroiled in what has been almost a never-ending restructuring of operations where it has endured layoffs and worldwide location closures.  If you have followed this company over the last 11+ years and since before the spin-off of Palm (PALM-NASDAQ) you will remember that this is the Boulevard of Broken Dreams of the publicly traded networking stocks in the US.   

Outside of TippingPoint (in intrusion detection) and H3C the companyhas almost nothing left so it is a leveraged gamble on management’sability to do what it hasn’t been able to do on its own in the past.My contacts at Cisco have told me point-blank that they just aboutnever run across this router in competitive bids like they were soworried about at first, so the ‘Cisco knock-off’ has not proven at allthat it is the ‘Cisco-killer.’  It has been a success for 3COM on arelative basis, but it will take much more to be a knock-out blow andis still geared more toward no-support-needed customers. There is noway to know how the new "Open Platform" for network infrastructure istreating the company, but investors who have had continual faith ingiving 3COM the benefit of the doubt have grown more than skeptical tooutright cynical. 

The year-over-year revenue gains were somewhat misleading because ofthe controlling stake in H3C that allowed the company to realize all ofthe revenues.  It was almost like counting Traffic-Acquisition Costsfrom web search companies.  It did post a non-GAAP positive quarterbefore a loss on a GAAP basis, so the pressure to keep posting.

At least it has Edgar Masri as CEO, but Eric Benhamou is still theChairman.  Benhamou would have been listed on a permanent "List ofCEO’s That Need to Go"
with the exception that he is now a non-executive Chairman and has beenout as CEO for some time.  The perception is that he is still far tooinvolved and gets in the way, but that is because the stock has slidfrom a mega and multi-billion operator that had US Robotics and Palmunder the same roof to a third-tier operator worth only $1.6 Billion inmarket cap.  If anyone would have predicted back in 1998 that the fallfrom grace would have been this bad, most on Wall Street would havelaughed the doomsday prediction out of the room.

There are two avenues that can ‘save’ COMS: Private Equity and/or aWhite Knight.  There has been all sorts of speculation that privateequity is going to come to the rescue (similar to the SunMicrosystems-SUNW investment) with a large investment to ramp up theH3C router efforts.  There has also been some speculation that a largerpublic networking company would want to nibble into 3COM to take thisH3C operation over before Huawei can legitimately and legally go backafter the space.  The H3C purchase price and new financing secured hasleveraged the balance sheet much further and now investors cannot eventip-toe into a COMS stock purchase with an assumed $2.50 cash floor asthey could in the past.

So the company could have a rescue attempt made, but this is still fromthe outside and the industry risks against 3COM are now greater andstronger than ever.  Cisco (CSCO) is king, Alcatel-Lucent (ALU) ishuge, Ericsson (ERIC) bought Redback, and Siemens & Nokia partnerednetworking operations.  This doesn’t even note the ongoing second-tiercompetition from Motorola (MOT) or Nortel (NT) and doesn’t account fora coin-toss on Juniper’s (JNPR) and other second and third tierplayers.  Outsiders looking in would have to be quite visionary andquite nimble to pull this off, and it would be a wonder as to whyanyone would risk the hundreds of millions or billions of dollars toattempt it. 

We truly hope the company CAN have a future, but any analyst knows thatthe odds remain stacked more in favor of others than they do in 3COM.With that sort of caveat long and short investors are either betting this one grows exponentially or that it implodes, but this isn’t the sort of lower-risk profile investment where investors will risk the funds for a 10% to 20% gain.  As for the stock, COMS is just north of $4.10, well short of the $5.70highs and close to the $3.82 lows over the last 52-weeks.

Jon C. Ogg
February 22, 2007

Jon Ogg can be reached at jonogg@247wallst.com; he does not own securities in the companies he covers.