3Com Bear's Rebuttal
by Jim Surowiecki ([email protected])

Between the time I wrote my first bearish take on 3Com and the time I'm writing this rebuttal, the company issued its latest earnings report, and after perusing it I think the question I asked in the first piece has been answered. In other words, if there is any sanity left in this market at all, shorting 3Com is the way to go.

Let's see. Year-over-year earnings fell 96%, to just 2 cents a share, which was a full twelve cents shy of estimates. The prices of 3Com's modems and switches, its main sources of revenue, have declined sharply because of competition and weakness in Asia. Sales dropped across the board in an industry that -- if you believe everything you read -- is booming, and in which 3Com's major competitor, Cisco, is enjoying annual growth in sales and earnings of close to 30%. 3Com CEO Eric Benhamou was typically optimistic, assuring us that all the inventory problems are solved now and that the company is back on a growth path. But 3Com now says long-term gross margins will be permanently lower, around 46%. Pauly suggests that these margins are still "quite healthy." But I think John Chambers of Cisco put it best when he said: "When I see 50% margins, I'm dying." 3Com won't see 50% margins again in our lifetime.

Of course, this has become a market in which investors seem so convinced that stocks can only rise that even companies with declining profits and sales can see their stock prices go up in the short term, so any short is dangerous. But 3Com is a company in serious trouble, having essentially lost an entire year of business because of the botched merger and its failure to maintain a hold on its core markets. It's easy to be sucked in by the idea that because networking is the wave of the future, any networking company is a good investment. But as investors, it's our responsibility to direct capital to those companies that perform and that have truly excellent long-term prospects and to direct it away from those that do not. By that standard, there's simply no case to be made for investing in 3Com.

The truth is that even if 3Com had met earnings estimates in this latest quarter, it would still have been enormously overvalued. As I've said before, if you buy 3Com that means you're not buying Cisco or Microsoft or Gillette or a hundred other better companies. At this point, with 3Com trading at a P/E of more than 55, this stock has half a decade of good news already priced into it. Bullishness feeds on itself and lets weak companies coast along with the strong. But eventually people wake up, and when they do, 3Com's tumble is going to be very steep.

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