3Com Q1 '97
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3Com Q1 '97
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(FOOL CONFERENCE CALL SYNOPSIS)* By Debora Tidwell (MF Debit)
3Com Corporation <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: COMS)") else Response.Write("(NASDAQ: COMS)") end if %> UNION CITY, Ca., September 24, 1996/FOOLWIRE/ --- 3Com Corporation, a leading global data networking company, today announced record sales and earnings for the first fiscal quarter of 1997, ended August 31. Sales for the quarter totaled $707 million, an increase of 42% from Q1 1996. Net income for the quarter was $93.1 million, an increase of 62% from the year-ago period. Earnings per share for the quarter were $0.52, up 58% from the same quarter a year ago, and beating consensus estimates of $0.50 per share by $0.02.
Sales of systems products, which includes switches, hubs, and internetworking platforms, totaled $416.4 million, an increase of 38% from the same quarter a year ago. Sales of network adapters totaled $283.3 million, an increase of 52% from the year ago period.
"Our first quarter results underscore the positive impact of our strong new product cycle and the continued rise of our reputation and share across our strategic markets, including network adapters, workgroup switches and hubs. This foundation fuels our resolve to establish 3Com as a clear leader in the systems business while extending our leadership in the interface products business," said Eric Benhamou, chairman and chief executive officer of 3Com Corporation.
MANAGEMENT REMARKS:
INDUSTRY TRENDS
The company's statements about the health and vigor of the networking industry have gained more credibility over the last couple of weeks. The combination of strong earnings results throughout the industry, new product announcements, and upbeat trade shows like Networld+Interop in Atlanta have caused any lingering worries about the growth climate in the networking industry to recede. This is in sharp contrast with the general uncertainty associated with technology growth that many felt in the June/July timeframe.
3Com's estimates of the pace of this growth have not changed -- 30-50% for the network systems market and 16-25% for the adapter market. These estimates have been bolstered recently by the confirmation of the robust growth rates in the PC industry as evidenced by Intel's recent results. However, the primary growth drivers in the networking industry continue to be other than simple unit growth in PC shipments.
One such driver is the broad-based transition from Ethernet to Fast Ethernet. While they always expected this to be more natural and more rapid than other technology transitions in their industry, they are surprised to see how fast it is now occurring. They consider themselves to be probably the best-positioned networking vendor to ride this multi-year transition, given that they are now selling more Ethernet or Fast Ethernet connections, both on desktops and in wiring closets, than any other company in the world. In Q1 alone, for example, 3Com shipped more than 7 million network connections between PCs and wiring closets. If you look at the PCI bus segment (and most Pentium desktops today come with a PCI bus), the proportion of 10/100 adaptors is now 50% of the mix, up from about 25% a mere six months ago.
Another major growth driver is the rate of deployment of intranet within large and medium-size enterprises. The intranet wave is gaining strength and has 3 major implications for 3Com's industry. First, intranets consume enormous amounts of bandwidth and require an upgrade of the connectivity infrastructure to fully switched mesh. This means a combination of high function switching for the data center and boundary switching for the edge of the network. As a result, 3Com feels quite bullish about the sustainability of the market momentum behind switching. Their recent new product introductions last June and last week at Networld+Interop Atlanta should not leave any doubt about how aggressive they intend to be in this part of the market.
Second, intranet is a single protocol family. All intranet packets are IP packets by definition. Consequently, intranet traffic flows can be accelerated if, instead of going through classical multi-protocol routers, they get moved through intelligent IP-aware switches. 3Com's fast IP technology in their high function switches enables them to switch and route IP packets at wire speed and bypass the overhead of traditional multi-protocol routers.
Third, intranets create vastly different traffic patterns. If FNE networks are the epitome of stable and predictable and centralized traffic flows, intranets live at the total opposite end of the spectrum. The Web makes it easy to navigate from server to server and to be both a publisher of information and a subscriber of information. This fundamental change makes it a requirement for any MIS organization to monitor and analyze traffic flows at the application level to understand which users tend to access which servers and when, in order to maintain an acceptable level of service across the network. This is why the importance of the Armand 2 technology is so strategic. The acquisition of Axon Networks last March now plays a pivotal role in their intranet strategy because it enables them to offer advanced network management tools to their customers to help them understand what is really going on inside their networks.
Another important growth driver for the industry is the continued deployment of remote access services. This phenomenon is unfolding through the growth of network service providers who offer public remote access services and through the growth of the remote access infrastructure on enterprise customer premises. It is fair to say that 3Com did not ride the first wave of this trend as well as some of the smaller and more focused companies like Ascend or Shiva. However, in the last 3-6 months they have introduced a new platform, the Access Builder 5000, for both the enterprise market and the telco market, which is the first to accommodate the multiplicity of different line services from traditional analog lines to ISDN to DSL services and also data-over-cable services. The Access Builder 5000 continues to garner top industry awards and is beginning to appear in the future plans of 3Com's largest customers. They intend to leverage positive early market feedback to gain share and establish themselves as one of the leaders in the remote access segment.
Finally, another important industry trend is the growing attention given to very high speed technologies such as ATM and gigabit Ethernet. It is inevitable that the rapid transition toward Fast Ethernet will soon create the need for higher speed aggregation technologies. They are quite convinced that both of these technologies will co-exist and thrive over the next few years. Three months ago 3Com described some of the large ATM network projects they had recently won. The Adobe network has now been installed and is up and running using 3Com's Cellplex product line. The momentum behind ATM in the backbone is definitely accelerating. They are also convinced that within a year, perhaps 18 months, gigabit Ethernets will offer an attractive alternative with a different trade-off between price/performance and quality of service. 3Com stands firmly behind both of these technologies and has announced ambitious extensions to their product lines in support of both ATM OC-12 and gigabit Ethernet.
COMPETITIVE LANDSCAPE
Over the last few months 3Com has continued to pull away from Bay Networks and Cabletron in growth rates, in products, in market share, and in market capitalization, and has become more firmly entrenched as the second-largest networking vendor in the industry. They also have been pulling away from Intel and some of their smaller competitors in the adaptor market. As a result, over the last 6 months not only have they extended a market share lead in network adaptors, both Ethernet and Fast Ethernet, but they have also shipped more hub ports than anyone else and have become #1 in hubs as well, while maintaining a close #2 ranking in switching.
They intend to remain the clear leader at the edge of the network. However, in the core region of the network, they are clearly confronted with Cisco who is today the largest overall vendor in their industry. In the core region of the network, namely the data center and the point of presence (POP), they think 3Com has a unique opportunity to become the most natural and the most legitimate alternative to Cisco. They intend for the 3Com alternative in the core region of the network to be quite different from Cisco.
For one, they are emphasizing open standards much more broadly throughout their products and their network architectures. Second, they are increasingly leveraging the intelligence of the network adaptor and the desktop connection to facilitate the management of switched networks as evidenced by the launch of dynamic access adaptor software introduced last quarter. Third, they do not subscribe to the theory of a market need to create proprietary integration across the LAN/WAN boundary. Instead, they plan to make this interface the strong and visible line of open demarcation between the customer premise network and the public network. As a result, customers will be presented with a very real choice between two different approaches of how to build network infrastructures.
PROGRESS REPORT ON KEY STRATEGIC DIRECTIONS
The first point focuses on entering the strong new product cycle. Between their June introductions and their Networld+Interop introductions, they are on track with all of their new product programs. They already saw the positive impact of their Fast Ethernet XL and their dynamic access software introduction in Q1, as well as the rollover from SuperStack to SuperStack 2 for their entire line of stackable systems. Their new product ratio moves from 33% last quarter to almost 50% now. As they move into Q2, many of their new high end product introductions will begin generating contributions, as well as their extended Token Ring range, including Token Ring Velocity Adapters and Token Ring switching products. In fact, it would now be conceivable that they will operate with a new product ratio in excess of 50% over the next couple of quarters.
The second point was a creation of two distinct and complementary centers of expertise within 3Com. One focused on systems and close relationships with end users and carriers. The other focused on interface products in relationship with distributors and other resellers. Three weeks ago they announced a restructuring of 3Com into two large organizations -- 3Com Systems and 3Com Interface Products. This change has been welcomed across the full range of 3Com's customers and partners. They have not missed a beat in this organizational transition and are using their new structure to accelerate decision making around two increasingly different but complementary aspects of their business. Over the next three months they intend to make a series of positive changes to their sales and marketing and support programs, and also to internal processes, to re-engineer and radically improve all the aspects of a 3Com customer experience. They are beginning to see some of the early results of changes begun a few months ago. In last week's issue of Computerworld, for example, 3Com scored #1 in the overall annual survey of user satisfaction, ahead of Cabletron, Bay Networks, Cisco, and IBM. This was a clear sign of progress over their rankings of a couple of years ago.
The third point was the growth of their internal infrastructure from the level of a billion dollar organization to that of a multi-billion dollar company. On that score, they are pleased to report three important milestones.
One is the successful transition of their MIS system to SAP R3 for financial and order management. They had completed the first part of this transition during the holiday shutdown last December and completed the final part of the conversion over the Labor Day weekend, including what used to be the Chipcom organization in the East Coast. They now have a seamless order entry and financial management system across all of their divisions worldwide and, to the best of their knowledge, are the first large vendor in the networking industry to have successfully completed this important system transition.
The second milestone is the expansion of their Ireland manufacturing facility. The addition of two new lines over the last few months will help them bridge the gap until their new Asian factory comes online. They intend to create a new market-oriented factory in Asia focused on the expanding ATR markets. They are coming very close to a final decision on its location, size, and cost and will communicate that at or before Q2 earnings release.
The third milestone is the recruitment of over 500 new employees around the world. This brings 3Com's direct headcount to a little over 5700 employees. For the first time in their history, 50% of these new recruits (approximately 250) were in a field organization. They are on track with the expansion of their selling capability which is an investment they mentioned about 6 months ago.
In summary, 3Com would like people to think about the following items when consider investing in 3Com. First, 3Com has now emerged as a clear #2 vendor in the networking industry. Second, they are extending their lead as the #1 equipment vendor in the edge region of the network and are fast becoming the most natural and legitimate alternative to Cisco in the core region of the network. Third, they have entered the strongest new product cycle in their history. And fourth, they are particularly well positioned to ride some of the most important technology transitions in the industry, including the transition from 10 to 100 megabits per second Ethernet, the transition from partial switching to pervasive switching throughout the enterprise, the acceleration of ATM as the backbone of choice for large enterprise buildings and campuses, and also the emergence of multi-service remote access solutions.
PERFORMANCE REVIEW OF Q1
Q1 was a very good quarter for 3Com with sequential growth in sales of 7% and earnings of 13%, which is at the high end of what they have historically seen in the seasonally slower Summer quarter. These results get FY 1997 off to a very solid start. Second, relative to their sales growth, they saw good growth in their systems business, up 6% sequentially, and very strong growth in their adapter business, up 10% sequentially. Third, relative to the financial model, operating margins improved just over 1% sequentially driven by a nearly 1% improvement in gross margins. With 54% gross margins, they are now operating at the upper end of their gross margin model of 52-54%. With operating income now at 20% they are right in the middle of their longer-term model of the high-teens to low-20s.
INCOME STATEMENT
Sales for the quarter were $707 million, a 42% increase from the year ago quarter, and up 7% sequentially. The breakdown of sales by product line was as follows: adapters were $283.3 million (40% of the total), up 10% sequentially and up 52% over the Summer quarter a year ago. Systems were $416.4 million (59% of the mix), up 6% sequentially and up 38% over the year-ago Summer quarter. And, the "other" product category constituted $7.3 million in sales (1% of the total), off 14% sequentially and off 23% from the year-ago quarter. In the Q4 conference call 3Com told people to expect that they would make a slight modification to their product line reporting this quarter. They have shifted service and support revenues out of the "other" category and into systems. This was done because service has increasingly become the critical element of their forward-looking strategy and is typically sold when they sell systems. This also makes for more accurate comparisons of their growth rate with those of their primary systems competitors.
ADAPTER BUSINESS
This was a very strong quarter for the adapter business. The 52% growth rate from the Summer quarter last year to this year represents their best year-over-year growth rate since the third quarter of FY 1995 when sales were up 54% over the year ago quarter. In fact, over the past 3 years these are the only 2 quarters in which their adapter growth rate (same quarter over the previous year) has been above 50%, furthering the point that they are enjoying growth in this business that is approaching all-time highs. And, a 10% sequential growth for the Summer quarter was exceptional. It may be the best sequential growth rate adapters have ever shown during a Summer quarter. In fact, in two of the past 3 Summer quarters including last Summer, adapter sales actually declined sequentially. They think it is safe to say that the adapter business is smoking right now.
The drivers of market growth, in general, remain the same ones they have cited before -- solid sales of new PCs; increased demand for networking; and the transitions from 10 megabit per second to 10/100 megabit per second, from ISO bus to PCI bus, and from desktop to mobile products. Growth in 3Com's adapter revenue during the quarter was driven by solid growth in desktop Ethernet adapters and rapid growth in demand for Fast Ethernet adapters. They saw good revenue contributions from new products, including the Fast EtherLink XL card they introduced in June. Although they have yet to see published market data for the Summer timeframe, it is their guess that growth in their adapter business was also driven by market share gains, particularly in Fast Ethernet. Unit shipments for the quarter were approximately 3.4 million units and aggregate average selling prices changed very little sequentially.
SYSTEMS BUSINESS
The systems business showed good growth in Q1. Revenues increased 6% sequentially and continue to benefit primarily from success in stackable systems, LAN and ATM switching, and internetworking products. Their stackable systems business experienced another strong quarter driven by market demand and the uptake of the new SuperStack 2 product line which was launched in July, along with the OfficeConnect product line launched last Spring. According to the market research firm Del Oro Group, 3Com now has almost twice the share of its nearest competitor in stackable hubs with 31.5% of the market. In addition, according to Del Oro Group, 3Com is the leading worldwide hub company with total market share of 17.5%.
Their switching business, which includes both LAN and ATM switches, continues to benefit from the overall strength of the switching market, particularly in the workgroup switching and ATM areas. The Cellplex line of ATM switches continues to be a strong contributor to the year-over-year systems growth. The Cellplex 7000 just won the Datacomm Tester's Choice Award with almost flawless performance. As they put it, "in a word, ATM as it should be done." Overall the ATM market has taken off and is red hot. Customers are building very large-scale ATM networks with both edge and backbone ATM switching products, similar to the Adobe network described earlier. Internetworking business enjoyed a good growth quarter buoyed by a strong demand in router products as the migration of SNA legacy networks continues and the increase in commercial demand (i.e., accessing the Internet) continues. It is interesting to note, again according to the Del Oro Group, that 3Com has moved up to the #3 market share in this segment, only a fraction of a percentage point behind the current #2 (Bay Networks).
SALES BREAKDOWN BY GEOGRAPHY
The breakdown of sales between the US and international markets is as follows: Sales in the US in Q1 were $365.7 million (52% of the total), up 13% sequentially and up 49% over the year ago quarter. International sales were $341.2 million (48% of the total), up 2% sequentially and up 35% over the year ago quarter. Sequentially, sales in the US were up strongly relative to their Summer pattern over the last several years. The sequential increase in international sales was in line with their pattern over the last several years. European sales were up, albeit slightly, which was encouraging after the down sequential quarter they experienced there in Q4.
MARGINS, EXPENSES, OPERATING INCOME, ETC.
Gross margins were up sequentially by almost a percentage point at 54% versus 53.1% in the prior quarter. The primary drivers of the increase in the gross margins were the favorable impact of new product introductions and product cost reductions, particularly in the adapter, switching and hub businesses. Relative pricing stability also contributed to the gross margin improvement.
Expenses as a percentage of sales were down 0.2% sequentially to 34% from 34.2% last quarter. The mix of expenses remained largely consistent from quarter to quarter. Headcount at quarter end was 5726 compared with 5190 in the prior quarter. Almost half of the headcount increase was in field sales support and service.
As a result of the increase in gross margins and decrease in operating expenses as a percentage of sales, operating income was 20%, up from 18.9% in the prior quarter. Other income grew slightly from the prior quarter, consistent with higher cash balances and slightly higher interest rates. Their tax rate increased slightly to 35.5% versus 35% in the previous fiscal year. Based on what they know today, they would expect this rate to hold for both this fiscal year and next fiscal year. The absolute number of shares outstanding at quarter end was 169.9 million, an increase of 1.1 million from the prior quarter. The weighted average share count used to compute earnings per share was 179.4 million. Earnings per share for the quarter was $0.52, up from $0.46 the previous quarter, a 13% sequential growth rate.
BALANCE SHEET HIGHLIGHTS
The balance sheet remains healthy, with cash and equivalents growing $78 million to $577 million. As projected during last quarter's conference call, receivables DSO increased from 49 days to 53 days sequentially. This increase is in line with historical patterns, as DSOs have increased between 2 and 4 days from Q4 to Q1 in each of the last 4 years. Reiterating what they said in the last conference call, they believe DSOs in the low to mid-50s are reflective of the expected longer-term shift in their sales mix towards more international and systems-oriented sales.
Inventory turns improved during the quarter to 5.6 versus 5.4 in Q4. Again, as mentioned during the last conference call, inventory is a balance sheet category where they believe they can do better. They are not doing poorly in inventory turns, but longer-term they would like to do inventory turns of 6 or greater and they were pleased to see progress towards that objective during the quarter.
LOOKING FORWARD
They like to outline factors for consideration when thinking about their business going forward and here are a few. One, as described earlier, they are enjoying a strong new product cycle for both their adapters and systems businesses. Revenue from new products is on the uptick and they would expect that to be true in Q2 as well.
Two, Q2 is seasonally a strong quarter for them, benefitting from having the three Fall months all in the same quarter.
Three, margin expansion in Q1 was very good, so good that they have already reached the objective of achieving 20% operating income by the end of FY 1997. They asked that people please not expect them to push that objective upwards. They continue to believe that investments in their sales organization and end-user marketing are important strategic investments. Having reached 20% operating income, they believe long-term shareholder interests are best served by emphasizing growth and investments that can best generate growth.
Four, the investment in their sales organization is not a one-time event. They will continue that investment and they do not expect to see a return on that investment in the short term due to training and sales cycles.
Five, they have described a strong new product cycle and, as always, the real test will be in the marketplace which is forthcoming.
Six, they are optimistic about their industry and 3Com's position in the industry. Industry growth continues to be strong and 3Com, over the recent past, has risen from an also-ran to the 2nd largest networking vendor in the world. Their objectives remain the same as they have been in past years, to grow faster than the market in FY 1997.Six, they are optimistic about their industry and 3Com's position in the industry. Industry growth continues to be strong and 3Com, over the recent past, has risen from an also-ran to the 2nd largest networking vendor in the world. Their objectives remain the same as they have been in past years, to grow faster than the market in FY 1997. * 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. |
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Copyright 1996, The Motley Fool |