Description

THIS IS A CHEAP STOCK!
Although 3COM has looked cheap for a while, I've stayed away from it this year for two reasons: concern about the company's continued huge cash burn (will they have any cash left before it stops its losses?) and a lack of a potential catalyst to get the shares moving (what's going to make someone want to own this one?). It now appears to be time to take a look at this baby.

How cheap is 3COM? The stock is currently trading at 0.68x book value (0.80x excluding goodwill). More importantly, $1.445B (93% of the current market cap) is in cash and marketable securities.

Price/earnings ratios are not useful because the company is still suffering from losses. Looking at price/sales, the company currently trades at 0.67x trailing numbers. Doing a screen of 64 computer networking companies, this is the 13th lowest in the group. The sector's range is from 0.07x [Entrada Networks -- ESAN] to 19.16x [Falconstor Software -- FALC] with a median of 2.19x and a mean of 3.65x.

Importantly, of companies with market caps above $300MM, 3COM is lowest. The nearest competitors are Black Box [BBOX] at 1.27x and Novell [NOVL] at 1.29x) -- almost twice 3COM's level!

A RESTRUCTURING HAS TAKEN PLACE... A BRIEF OVERVIEW OF 3COM TODAY
Over the past year, 3COM has dramatically restructured to reduce its losses and provide a base from which it can grow. The company has cut its workforce from 12,000 to a projected 6,000 at the end of November. It has also outsourced a significant portion of manufacturing and cut product lines that weren't working. The company is now composed of three divisions:

* Business Networks Company (BNC) [$195MM Q1:02 Rev, -5% Q/Q, 51% of company revenue] provides network infrastructure solutions for the enterprise and small business markets. BNC develops three categories of products: LAN infrastructure, composed of hubs, switches and solutions; networked telephony systems for voice over existing network connections; and wireless access points and adapters based on Wi-Fi technology.
* Business Connectivity Company (BCC) [$125MM Q1:02 Rev, -23% Q/Q, 33% of company revenue] provides products that enable network computing: Ethernet desktop Network Interface Cards (NICs), Ethernet server NICs, Modem PC cards, LAN CompactFlash Cards for Windows CE environments, and Bluetooth PC Cards.
* CommWorks Corporation (CommWorks) [$60 MM Q1:02 Rev, flat Q/Q, 16% of company revenue] provides Internet Protocol (IP)-based access and infrastructure and services platforms for the telecommunications service provider market. CommWorks is able to migrate telecommunications service providers to IP, with network solutions based on the CommWorks architecture. This three-tier, carrier-class solution architecture allows telecommunications service devices to access computer networks

CASH FLOW HAS BEEN HORRIBLE... COULD AN INFLECTION POINT BE NEAR?
Anyone who has been peripherally aware of 3COM knows that it has burned through a boatload of cash. In the past fiscal year (ended in May), the company's operating cash flow was a negative $993 million! This occurred as the company's marketplace, competitive position, and revenues simultaneously imploded. (To give you an indication about the magnitude of the turnaround, 3COM generated positive operating cash flow of $827MM in fiscal 2000 and $984 MM in fiscal 2000).

Preliminary indications are that these cash flow losses are about to be staunched. With the restructuring finally implemented, the company is getting closer to being aligned with its business prospects. The company previously indicated that it expected ongoing operations to be near operating cash flow breakeven for the quarter just wrapped up at the end of November. (The company will still burn through $200 million in cash related to restructuring costs). While I'm not sure the company will meet this objective, I believe the company could make any necessary adjustments to achieve this goal by the May 2002 quarter. If this happens, investors will stop asking "How much cash are they going to burn" to "How much can cash can this company start to generate?" Assuming that the company will stop its cash burn, analysts project that 3COM's cash levels will bottom somewhere between $1.0-$1.2 billion over the next few quarters.

R&D SPENDING CONTINUES... NEW PRODUCTS COULD ACTUALLY LEAD TO GROWTH!
One of the things I like looking at 3COMS financials is that it has continued to invest heavily in research and development (R&D). Although the absolute level of investment last quarter dropped to $86MM from $146MM in the prior year's quarter, the company increased R&D spending as a percentage of sales from 16% to 22%. It's a very good sign to see a company in the midst of major cutbacks to value new product development(particularly when it has the cash to do so and some interesting areas to pursue).

Many of the company's traditional markets seem to be mature, in decline, or at a point where 3COM isn't that competitive. That's why the company is focused on new areas (particularly those associated with wireless connections) that could offer extraordinary potential.

The analyst reports I've read are most enthused about CommWorks, the division that actually had flat (rather than declining) sequential revenue. The continued rollout of IP Telephony, combined with products that can assist with the rollout of CDMA-based 2.5G and 3.0G products seem to be the biggest potential products.

Not mentioned as frequently, but products I can imagine being very important to the company, are "Wi-Fi" wireless network infrastructure products. These allow companies and individuals to set up wireless networks. From the press reports I've read, this business is really getting ready to blast off. (For more information on this technology, look at research on Intersil [ISIL], the dominant makers of Wi-Fi chips).

3COM also has released some Bluetooth cards, which could emerge as important products down the road. (These are used to wirelessly connect a computer with peripherals such as printers, PDAs, and digital cameras)

MANAGEMENT
I don't have any perspective on the management team that has taken the helm of 3COM. Knowing that a lot of you focus intensely on management, I pulled this information from the company's web site.

In January 2001, Bruce Claflin was promoted from President and COO to CEO and President. His background includes a couple of years at Digital and 22 years with IBM. Irfan Ali, head of Commworks, has been with the company since 1997. His prior experience includes work at Newbridge Networks and Nortel. Dennis Connors, the president of BCC, joined 3COM at the end of 1999 from Ericsson. John McClelland, president of BNC, came to 3COM in March 1999 after twenty years at IBM, Digital Equipment, and Phillips. Michael Roscoe, the CFO, joined 3COM in April 2000 after serving as CFO at PG&E. Eric Benhamou, the company’s longtime CEO, remains chairman of the board.

OPTIONS ISSUES
3COM has an obscene option liability, with 148 MM shares (equivalent to 43% of company shares) at an average strike price of $7.80 as of June 1, 2001. This liability has been caused by generous option plans made much worse by dynamics associated with last year's Palm spinoff. Looking at the 10-K option review, the majority of the option dilution will not occur until the stock rises above $6, 30% higher than the current prices.

As a side note, the option liability will likely be reduced as a result of the recent firings (less than half the outstanding options were exercisable as of June 1).

SUMMARY (Finally!)
I see 3COM as a stock with limited downside risk because of its cash cushion and enormous upside if its restructuring brings costs in line and new products start to generate meaningful revenue (and profits). The biggest risk is the magnitude of operating cash burn. While last year's burn was almost unimaginable, restructuring efforts will bring this figure down dramatically this year. Growth opportunities are hard to quantify, but everything I'm reading indicates that the opportunities in all types of wireless networking are pretty impressive. COMS's history in networking, combined with substantial resources to invest in R&D, give the company pretty good odds to achieve some type of success.

Best of all, the current below-tangible-book stock price incorporates only continued disappointing announcements from 3COM. It doesn't give any value to the potential opportunities in front of the company.

Catalyst

1) Indications that the company's operating cash burn is actually subsiding (possibly as early as the earnings release for the quarter that ended in November)
2) Speculation that one of its three business segments will have a "hot" product... i.e., bluetooth cards, Wi-Fi (802.11b) wireless network infrastructure products, Voice-over-IP gateways, or CDMA-related 2.5G and 3G wireless solution.
3) An inflection point in revenue declines. (Y/Y sales have been down 35%-58% over the past four quarters... these kinds of declines are likely to moderate in a quarter or two.)
4) Buying caused by investors wishing to dip their toes back into tech, but wanting to avoid the obscene valuations so many companies have. (3COM is also a good choice for many folks because it isn't a microcap and is fairly liquid)