3Com by the Numbers,
Following Quarter One
by Jeff Fischer ([email protected])

ALEXANDRIA, VA (Sept. 24, 1997) -- The second-largest networker in the world, 3COM <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COMS)") else Response.Write("(Nasdaq: COMS)") end if %>, announced pro forma earnings that were in line with estimates of $0.48 per share. First quarter sales rose 28% from last year, to $1.6 billion.

Rather than reiterate the press release, which is available anywhere, we'll run some current valuation measures on the company following the earnings announcement. The full conference call summary is also available from the Motley Fool.

Grabbing the company snapshot, we see that the U.S. Robotics merger has not yet been accounted for in the trailing results shown. So... we hop on over to the 3Com Web site to get some of the numbers that we need, listed under the "News/Events" and then "Press Releases" link. But this isn't always good enough. So we also need to head over to the SEC EDGAR page to dig up the latest 10-Ks, 10-Qs, and merger-related material on 3Com.

Combined with U.S. Robotics from now until the end of the world (probably), we find that 3Com now has trailing revenue of $5.94 billion. The latest combined quarters, from the website, are given in billions as $1.25, $1.421, $1.426, and $1.50. To find the trailing sales we need to remove the oldest quarter ($1.25b) and simply add the new quarter. This gives us $5.94 billion in trailing sales.

We now move to the bottom of the earnings report and find that the shares outstanding are 341,973,000. Let's compare 3Com's market capitalization to sales. To get the market cap, we multiply the current stock price ($52) by the shares outstanding, resulting in market cap of $17.8 billion. This puts 3Com in the "large cap" category, by many measures, though when companies trading with $150 billion market caps are called large cap, too, it begs the question, "Is 3Com really a large cap?"

Maybe not. The company's earnings are expected to grow 27% annually over the next five years, which is much more robust earnings growth than most well known and so-called "large caps." Anyway...

With a market cap of $17.8 billion and trailing sales of $5.94 billion, the stock is trading at 2.99 times sales. For comparison, CISCO SYSTEMS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCO)") else Response.Write("(Nasdaq: CSCO)") end if %> and other networker ASCEND COMMUNICATIONS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ASND)") else Response.Write("(Nasdaq: ASND)") end if %> trade at about 8 times and 5 times sales. The price-to-sales ratio for a stock is influenced by the industry, expected growth rates, competition, margins, and cash and debt on the balance sheet. From the comparisons given, either Cisco and Ascend are richly valued, or 3Com is somewhat undervalued compared to its brothers.

All of these companies are growing at similar rates, and though margins at Cisco and Ascend have been stronger than 3Com's, 3Com's are far from weak. In the past, 3Com has had 18% operating margins and net margins of 12%. Cisco's have been 29% operating and 16% net. Ascend's, 31% and about 18%. In networking, the higher-end products produce higher margins. 3Com is the leader in less expensive products, including network interface cards (NICs), so the company has had lower margins. In the last quarter, though, 3Com reported that switches, hubs, and other internetworking product sales increased 34% from last year. The focus is on improving high-end product sales while increasing the healthy lead already achieved in remote access products. 3Com is the market leader in modems and NICs.

Figuring margins after only one quarter with U.S. Robotics is premature, as the dust is still settling. But let's take a look at the company's statement of statement of operations (on 3Com's website) for the last quarter. When you back out the merger-related charges of $426 million from gross profits, you have $263 million in operating profits, or 16.4% operating margins compared to last year's 18.9%. The 18.9% was achieved as separate companies, though -- with the numbers just slapped together. Pro forma net income, the money making it to the bottom line, would have been $172 million this quarter if not for charges. That results in 10.75% net margins ($172mm divided by $1600mm) -- again, slightly lower than the companies achieved separately. Let's give them another quarter, though -- a full quarter -- to see how these margins settle.

What is more important and relevant now are the gross margins. The common fear is that networking prices are coming down, sending gross margins lower, which would trickle all the way down the income statement, of course. We've yet to see this happen, though. INTEL <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %> apparently isn't crushing 3Com yet, forcing 3Com to slash prices and destroy margins. 3Com's cost of sales (the second line on the income statement) has not risen to a greater percentage of sales, which would have happened if prices were cut and volume didn't compensate.

With $1600mm in sales and $832mm in cost of sales, 3Com had $768mm in gross profit last quarter (see the top three lines of the same statement that we linked to above). This results in gross margins of 48%. Last year, the combined companies had sales of $1250mm and gross profit of $591mm, leading to 47.2% gross margins ($591mm in gross margin divided by $1250mm in sales = gross margin of 47.2%). This improvement is probably part of the reason the stock could react favorably. The company isn't seeing pricing pressure on the top line, and actually improved the gross margin.

Expected to grow 27% annually for five years and earn $3.12 per share in fiscal 1999 (ending May of 1999), the YPEG value on the stock (growth rate multiplied by the far estimate) is $84.24. Using the closer -- and more predictable -- estimate of $2.42 for the year ending May 1998, the stock's YPEG value is $65.34. At that price, 3Com would trade at 27 times trailing earnings -- a multiple equal to the growth rate.

The company has $1 billion in cash and only $295 million in long-term debt, so the enterprise value puts the stock at a multiple even lower than the price-to-sales multiple of 2.99. To get enterprise value, you subtract the cash and add the long-term debt to the current market cap and you have a $17.01 billion enterprise value ($17.8 billion market cap minus $1.08 billion cash, plus $295 million long-term debt = $17.01 billion). On that value, the stock trades at 2.88 times sales.

If the merger proves successful and 3Com can maintain or improve margins and meet estimates going forward, the stock is arguably somewhat undervalued at $52, or 21 times earnings estimates for the year ending in May. The Fool Port is holding its long-term position in 3Com. If 1998 and 1999 go as expected, the stock should appreciate by a significant degree over the next few years.

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