3Com Bull's Rebuttal
by Paul Larson ([email protected]@aol.com)

My associate Jim has the knack for melodrama. He also has a future in the traditional financial media if he so chooses. Why? Because he certainly has perfected the skill of making a big deal out of the story of the day while ignoring the larger picture.

You find no argument here that 3Com's recent performance has been nothing short of ugly. I guess whether you are bearish or bullish on 3Com boils down to whether you believe that the weakness of the last year is a normal dip in the business cycle or the start of a lengthy downward trend. Jim seems to think this is a major trend and that extrapolating the recent anemic earnings numbers out to their extreme ad infinitum is the best way to look at the company. I beg to differ.

There are several mitigating factors to consider when assessing the recent weakness. The first is a purely qualitative factor, but may be the most important. When 3Com merged with U.S. Robotics last year it was the largest merger in the networking industry to date. Just like any married couple, much of the company's time and energy has been put towards the actual pomp and circumstance of the wedding. The merger has meant much more than simply changing the business cards and letterhead from "U.S. Robotics" to "3Com." As such, it has caused the company to focus inward instead of where it should be -- outward on the market. Nevertheless, the fallout from the merger is just about settled, and the company is now properly focused.

Then there is the inventory situation. When the merger was consummated, the company's distribution channels were stuffed full as a Thanksgiving turkey. Little secret there. To correct this situation, the company put the inventory in the distribution channel on a crash diet. This process temporarily depressed the earnings numbers across the board -- top line, bottom line, margins, the whole shebang. However, this effect is a finite, limited one, and the company's inventory channels are now looking mighty lean. It simply does not seem prudent to extrapolate a trend on a one-time occurrence.

The third major circumstance to hit the company has been the delay in the standardization of the 56K modem line. The delay in acceptance of this new product has stunted the company's upgrade cycle in both the consumer and systems sectors. But now that a 56K standard has been agreed upon, the horse has been put ahead of the cart and the upgrade cycle can start in earnest. It should be noted that many of 3Com's modems can be easily upgraded to 56K via a software patch, something many of the company's competitors cannot claim.

Jim also cited the Asian situation as a reason to be concerned about 3Com going forward. I would not be doing my job as the bull here if I did not mention that 3Com is in the process of building several manufacturing facilities in that region. With the strong dollar and weak Asian currencies, these factories and the labor to fill them are much cheaper than they once were. This cost cutting should benefit the company across the board in the future.

Let me state again that there is no argument that 1997 was a terrible year for 3Com. But it was a dip in the cycle, not a trend towards bankruptcy as my associate would have you believe. The medicine certainly does taste bad, but the ultimate effect is to have a much healthier company going forward. The company's CEO Eric Benhamou recently said, "We have no more hurdles to cross..." and the company expects "strong improvements in our operating performance over the next few quarters." I have little reason to doubt Benhamou when he says the worst is behind the company. April showers bring May flowers.

Next: The Bear Responds