Conference Call, 06/25/98, 3Com Corp. Q4

FOOL CONFERENCE CALL SYNOPSIS*
By Jeff Fischer (TMF Jeff)

3Com Corp.
<% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COMS)") else Response.Write("(Nasdaq: COMS)") end if %>
5400 Bayfront Plaza
Santa Clara, CA 95052-8145
Ph: 408-764-5000
Fx: 408-764-5001
http://www.3Com.com

ALEXANDRIA, VA (June 25, 1998)/FOOLWIRE/ -- Networking leader 3Com Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COMS)") else Response.Write("(Nasdaq: COMS)") end if %> announced fiscal 1998 fourth quarter net income of $65.9 million, or $0.18 per share. Fourth quarter revenue totaled $1.375 billion, up a fraction from the same quarter of fiscal 1997. During fiscal 1998, sales totaled $5.42 billion vs. $5.60 billion last year.

For the past twelve weeks, sales of high-end system products (hubs, switches, remote access concentrators, routers, and management software) rose 22% from the previous quarter and 8% from last year, to $671 million. Client access products (modems and network interface cards, or NICs) saw flat sales of $704 million. Revenue in this segment rose 1% from last quarter and declined 6% from the previous year.

Fourth Quarter Highlights

Inventory Practice. The company has turned the corner and is on the path to the business model that was initiated in the last two quarters. The inventory model announced six months ago -- a much leaner model -- is now in place. 3Com's inventory model is leaner than the industry standard and much leaner than it was previously. This gives the company greater flexibility and more economic safety. 3Com reached its inventory goal at the end of the last quarter. Channel inventory practices moved from a bottom tier status to a top tier status. This operational issue has been nailed.

New products. Fiscal 1998 was a banner year for new products, with more being introduced in the past 12 months than during any 12-month period in 3Com's history. 3Com also won more "Best in Show" awards than any competitors last year. The company is beginning the new fiscal year with a full new product line. It's the market leader in the gigabyte switching category, with 25% market share, and it is second in the Layer 3 capacity switch category, with 32% market share. 3Com's Corebuilder 9000 completed its beta phase in Q4 and will be shipping in Q1. In the small and mid-size enterprise business, 3Com's new superstack ethernet switches and hubs have been shipping since February. The company is the market leader, with 51% market share, in Fast Ethernet, and is number two in the Layer 2 switch category with 26% market share.

Specifically in client access products -- 3Com's new Fast Ethernet silicon and NICs have been shipping for over a quarter. All categories combined in this segment grants 3Com 49% market share, while Fast Ethernet in this segment achieves 56% market share, making 3Com number one in each. Based on these numbers, 3Com continues to gain market share over Intel <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %>.

Cable and other emerging categories have strong potential. 3Com's CEO concluded this topic with, "Suffice it to say, we are in a very strong product position with limited near term technical and operational risks and in a great position to begin fiscal 1999."

Industry Outlook. Consolidation in the industry is far from over, as voice and data will converge on data networking infrastructures for both private and public networks. This is hardly a new trend. It's important to note, though, that different industry players have different starting points and different objectives.

3Com is in a unique position when it comes to these new technologies. Comparing the company directly to Cisco Systems , Bay Networks, Cabletron, Ascend, and other smaller competitors is not quite appropriate, because the scope of 3Com's business begins at the very edge of the network connection -- via the desktop/server/home computer/or mobile computer -- and extends to the very edge of the public network, or the multi-service universal access platform switching points. In this way, 3Com is increasingly different from Cisco Systems, a company that focuses on the full scope of the public network core (i.e., the switch to the router backbone).

3Com is also different from the large telecom equipment providers, and far broader in scope than its small competitors. From the small enterprise network to the large enterprise network, from the consumer to the Internet Service Provider (ISP), 3Com is the leader in all but for the large enterprise market, where it's second.

Another difference: Beyond the scope of its products, 3Com has chosen to partner with industry peers. Cisco Systems is unlikely to engage in deep partnerships beyond the "public relations" level, according to 3Com. While 3Com's partnership strategy is genuine and well-defined. 3Com is willing to have sincere relationships for shared benefit. (3Com's argument is that Cisco is too invested in most arenas to seriously partner with any company on large initiatives.) 3Com's other competitors -- those it wouldn't partner with -- are substantially smaller and are potential acquisition targets rather than partners.

As for actual partnerships: at the end of the network, 3Com works with Microsoft (Nadsaq: MSFT) and PC vendors. At the core network level, the ongoing partner is Siemens. 3Com shares with Siemens an assured vision of the market and a common architectural framework for the edge or core portions of the 3Com connection market. In addition the companies collaborate on technical, marketing and selling strategies.

3Com's scope of business, market coverage, and partnerships are the three elements that set it apart from competitors.

Strategy. The goal is to assure that the 3Com name is synonymous with the benefits of connectivity and to connect more people to information than any other company, from the enterprise level to small business, to individual users.

Emerging Growth Opportunities. With the U.S. Robotics merger behind it, the new 3Com is focused on growing outward. Growth opportunities exist in its traditional business, especially with several new products now shipping, but there are many new and exciting business niches that will grow at much faster rates than the networking industry average. There are four immediate new market opportunities.

ONE. The first is the connected organizer business, often called the palmtop market. Here exists a strong underlying market growth rate of 75% annually, and 3Com has the market leverage of a platform that it developed -- supported by partners like IBM and Oracle -- and the leading brand and market share alongside the leading installed base following the rapid acceptance of PalmPilot III. The long-term opportunity is excellent.

TWO. The next opportunity is in small and medium-sized markets for networking products. Growth rates are above the industry average and 3Com is already the market leader with an opportunity to grow its lead. 3Com has three strategies here -- 1) Increase retail presence from 20,000 retailers to 50,000 in the next year. 2) Leverage 3Com's "More Connected" campaign and brand. 3) Tap into its rich product depth to provide complete solutions to all customers.

THREE. A third emerging opportunity is the high speed access equipment segment for both cable and DSL for consumers and enterprise customers. The growth rate here should be in the triple-digit range for the next several years. 3Com is aiming for a leading position and is off to an encouraging start.

FOURTH. Home networking is a fourth emerging opportunity and 3Com is already the leader. You might have seen its home networking kits in computer stores. 3Com aims to offer simple and inexpensive solutions. It's expected this will be a billion dollar business by the year 2001.

CEO Conclusion. Fiscal 1998 was difficult, but 3Com's operational and strategic position are both far stronger now than they were one year ago, and the company is in a good position to improve upon favorable trends and move into emerging market opportunities. Management realizes that they still have a way to go before the company is operating at its full potential, but 3Com is strictly disciplined towards continuous improvement.

Financial Highlights

The fourth quarter was a good quarter that represented a turning point. There were several positives: sales grew 10% from last quarter and gross margins rose as well, albeit slightly; expenses were down sequentially; pro forma operating income increased sequentially by 5.3%; EPS grew sharply from Q3; shipment linearity was the best of any quarter in the fiscal year; cash grew by $175 million; inventories declined $125 million; accounts receivable and days sales outstanding (DSO) were at 56 days, being under 60 days for the first time in over one year. The belief is that 3Com has turned and is operationally headed in the right direction.

Several recent developments in Q4 should help. 3Com's Chicago manufacturing sites were consolidated to reduce costs, while employee headcount was reduced 6%. The company also launched its Singapore manufacturing site, which will reduce the tax rate in fiscal '99 by about 1%. 3Com also consolidated distribution sites in Europe to lower costs. Operating and marketing expenses declined aggressively.

Gross margins declined from last year due primarily to product price declines, but cash flow was strong thanks to the new inventory practices and tighter accounts receivables. Overall, expenses were at the lowest point last quarter than at any point in fiscal 1998, while cash grew to over $1 billion. To compare all expenses and margins year-over-year and quarter-over-quarter, please see the full earnings press release linked at the end of this synopsis.

Geographic Sales. U.S. sales totaled $712 million last quarter, representing 52% of total sales, up 6% sequentially and 11% from last year. Internationally, sales were $662 million, or 48% of total sales, up 15% sequentially and down 9.2% from last year.

Items for consideration. During fiscal 1999 the projected industry growth rate will be lower than any other year this decade, but the industry is still robust and 3Com is a vibrant participant. 3Com has the leading market share in several key customer markets, and is among the top three seller in virtually every market that it competes. Gaining market share is a goal. Layer 3 switching, gigabyte ethernet, cable, xDSL, and the SOHO consumer and home networking market -- expectations are high in all of these areas. Early palmtop success gives cause for excitement for other new markets. According to the company, Palm III and PalmPilots have had the highest uptake of any peripheral in history, including the PC.

3Com's channel inventory practices are now firmly implemented, while the modem market might grow more quickly eventually since the V.90 standard for 56k modems has been accepted. To date, the transition to 56k technology has been slower than expected and will probably continue to be so until we near the end of calendar year. Asia also continues to be an uncertainty and is not the growth opportunity that it was in years past. It's unclear when this will change for the better. But for 3Com, with the exception of its Corebuilder 9000, all of the new platforms announced last year are now shipping and nearly its entire product portfolio has been refreshed and expanded.

The company expects sales to PC OEMs (personal computer original equipment manfucturers) to continue to grow, and though these sales have lower ASPs (average selling prices) and gross margins, they have similar operating margins relative to non-OEM sales. The pricing environment remains especially competitive in particular segments, but it isn't unusually so in all product categories. Adapter ASPs declined less last year than during most years, for example. Pricing here will probably be more akin to traditional levels in the future, with declines of 15% to 20% on an annualized basis beginning in the second half of fiscal 1999. Of course, this isn't for certain.

The company aims for gross margins of 45.5% to 47.5%, expenses of 27.5% to 29.5% of sales, and operating income of 16% to 20% of sales. The goal is to improve the financial model each quarter until this ultimate model is achieved. That said, the upcoming Q1 is the most difficult, as quarter one is seasonally the slowest and is usually flat compared to Q4. Summer is slower and 3Com's fiscal year puts all three summer months in the same quarter. Europe is slowest in summer, too, and more sales have been in Europe for 3Com lately.

Still, inventory should decline further in Q1 and that is the leading indicator of gross margins. Gross margins should improve in Q1 by more than they did in Q4. The quarterly expense run rate declined $50 million per quarter the last few quarters, and expenses should decline as a percentage of sales in fiscal year 1999, too, but they're not expected to come down on an absolute basis. Some increase is expected in expenses, but below rate of increase in sales. The tax rate is dropping to 34%, at least, from 35%. Finally, the board authorized the repurchase of up to 10 million shares. With the stock in the mid-$20s, management wanted its options open. This doesn't mean that it will buy the shares for certain.

Question and Answer Session

Following are answers to questions asked: Remote access sales grew well above 22% for the quarter, though 3Com doesn't break out numbers precisely. That growth isn't sustainable, though. Much of it was due to the inventory correction in the previous quarter.

The breakdown given follows: Growth in adapters was down, modems were up more than average, switching was up but not as much as the increase in overall systems product sales. Client access products were up 1% sequentially. The V.90 modem transition is occurring more slowly than hoped and the spring quarter is not the strongest for the NIC business. Most NICs are sold to enterprise environments, while modems are sold to consumers, so the two products tend to be on opposite schedules for sales. (Modems sell well during the fourth calendar quarter.)

A total of 750 3Com ISP customers have upgraded to V.90, and about 1,500 ISP customers worldwide have the capability to do so and will be able to upgrade to V.90 easily. By the fall, 80% to 90% will have upgraded. Those without DSP modem architecture, or non-3Com customers, will take longer to upgrade. But the modem business should accelerate before the end of the calendar year as a critical mass of ISPs has upgraded to 56k modem technology and other networkers are releasing V.90 products.

3Com's inventory turn goal of six to seven turns is well below the four achieved last quarter, but that number, being an "average," was impacted by the new inventory practice and will improve. Inventory turns should increase and hopefully be nearer to six over the coming quarters.

International sales gained 15% sequentially, but Asia was the slowest growing of any international location and was less than 10% of total sales last quarter.

Finally, the search for a new COO is still taking place. This began in springtime. Statistically, it takes a company this size six to nine months to find a COO.

END OF SUMMARY.

* A Fool conference call synopsis represents an effort to highlight the salient points of a conference call and should not be taken as an authoritative accounting or transcription of the entire event. Note: Statements made by a company other than historical information may constitute forward-looking statements for which the company can claim protection under the Safe Harbor Act. Please consult the company's filings with the SEC for information on risk factors which might cause actual results to differ materially from the information contained in these forward-looking statements.