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Monday, December 15, 1997

Cabletron Systems
(Nasdaq: CS)
Phone: (603) 332-9400
Website: http://www.cabletron.com
Price (12/12/97): $14 1/16


A late 1996 promotional video shows a scrappy boxer labeled "Cabletron" pummeling the heck out of a flabby boxer called "Cisco." Unfortunately for Cabletron, this negative ad did nothing to attract new customers. Concentrating too much on going head-to-head with Cisco rather than sticking to its knitting and building a comprehensive, end-to-end line of network products is the principal reason why Cabletron has been flailing at the air lately.

Investors are concerned that the company has under-invested in research and development and acquisitions -- meaning that its product line is not robust enough to compete with industry heavyweight Cisco Systems (Nasdaq: CSCO) nor with its other arch-rivals, 3Com (Nasdaq: COMS) and Bay Networks (NYSE: BAY). Two quarterly earnings warnings in a row after an unblemished earnings track record since the 1989 initial public offering have absolutely destroyed investor confidence. Given the shape that the company is in, it seems unlikely that it will be back to its fighting weight anytime soon.


Cabletron Systems makes network equipment used to run local-area and wide-area networks. Originally starting with hubs that linked desktop computers, the company has moved into the fast ethernet local-area network switch business over the past few years. Cabletron has gigabit ethernet and frame relay switching technologies as well as remote access modules it sells with its LAN switches for WAN compatibility. The company resells asynchronous transfer mode (ATM) desktop switches manufactured by FORE Systems (Nasdaq: FORE).

Cabletron's main competitors in the hub and LAN switching space are Cisco, 3Com, Bay Networks, FORE Systems, Newbridge Networks (NYSE: NN), Madge Networks (NYSE: MADGF) and Intel Corp. (Nasdaq: INTC). In frame relay and remote access the company goes head-to-head with Cisco, 3Com and Ascend Communications (Nasdaq: ASND). The company's strategy to differentiate itself has been to focus on developing networks that are entirely switched as an alternative to using routers manufactured by Cisco, 3Com, Bay Networks, and Ascend. This strategy has not been working.


Income Statement

12-month sales: $1481.5 billion
12-month income: $244.5 million
12-month EPS: $1.56
Profit Margin: 16.5%
Market Cap: $2217.7 million

Balance Sheet

Cash and securities: $365.3 million
Current Assets: $1030.5 million
Current Liabilities: $228.3 million
Long-term Debt: None

Price-to-earnings: 9.0
Price-to-sales: 1.5


Cabletron's explanation of its first major earnings disappointment in early June was a little too pat. Weak European sales and difficulties getting enough semiconductors to manufacture its new SmartSwitch 6600 in volume killed a 20%-plus grower overnight? Co-founder Robert Levine's resignation shortly after signified that there had been a little more ball dropping than just a few wet-behind-the-ears European managers. Although Chairman Craig Benson brought in ex-NYNEXer Don Reed to run the show, apparently Levine's departure and the poor execution by European managers completely demoralized the sales force.

On top of this internal turmoil, Cabletron's long-term strategy of trying to draw attention to itself by one-upping Cisco was just not happening. The company was consistently late getting into new technology and in chronic denial over whether or not routers were important. The company only grabbed router technology in September and gigabit ethernet technology in June, well behind its major rivals. Even the recent purchase of Digital Equipment's networking unit is weak sauce -- although it increases Cabletron's European sales by more than 40%, the company does not get a significant technological boost or much help fending off its chief rivals at home.


In business, there is an old saw about how the excess returns go to the top three in any market. By excess returns, we mean investment returns above the cost of the capital invested. Although Cabletron has had a number of fat years over the past decade, with number two 3Com and number three Bay Networks reduced to struggling shells by industry titan Cisco Systems, it is hard to imagine a universe where Cabletron starts to command high margins or retakes the technological vanguard. Although a merger with OEM-partner FORE Systems is a real possibility, the company's discredited ATM-to-the-desktop plan isn't playing in Corporate America.

Although cheap by conventional rear-view mirror valuation standards, an investment in Cabletron is an implicit bet that any market opportunities left untouched by Cisco Systems are not grabbed by the much more acquisitive 3Com, Bay Networks, or Ascend Communications. The fact that Cabletron options pretty much became worthless over the past six months for most senior personnel also brings up the specter of brain drain. Should the networking world go the way of the desktop world, continued consolidation toward a limited group of standards should benefit Cisco, 3Com, and potentially Bay Networks.

If the Cabletron of the future only earns 10% net margins on sales growing in the 15% to 20% area (assuming the Digital acquisition adds about $300 million to the current trailing sales base), the company trades at 12 times earnings. Investment for the 25% to 30% upside must be balanced against the risk that the company might continue to crumble over the next 12 months or so as it struggles to right itself.

-- Randy Befumo

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