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3Com to Miss Q2
December 03, 1997

Inventory a Problem at 3Com
by Randy Befumo (TMF Templr)

3Com Corp. (Nasdaq: COMS) closed down $3/8 to $34 15/16 after being off $3 9/16 on announcing a sweeping reorganization of its inventory strategy. The world's second-largest manufacturer of connectivity gear informed investors it would seriously miss current second quarter earnings estimates on much lower-than-expected sales as it sought to clear out excess inventory from the sales channel. Investors have been worried for weeks that inventory levels for the company were out of whack, sending the shares spiraling from their October perch in the high $50s. A number of analysts cut earnings estimates and lowered their ratings in the wake of the news.

3Com has been struggling since June to reconcile the conflicting inventory management of its new U.S. Robotics subsidiary with the rest of the company. As recently as a month ago, Chief Executive Eric Benhamou confessed to investors that the company had no idea how much inventory was actually in the sales channel and would not know until January. Last night the company basically said that enough was enough and announced a sweeping reorganization of its entire inventory strategy in an effort to put an end to its inventory woes. After quite a bit of work, the company determined that all stakeholders would be best served by its new plan and that this plan should be implemented post-haste. Gradual implementation was rejected because it would have produced lower-than-expected results for more than year.

The new plan drastically shortens the amount of inventory 3Com will keep in the channel at any one time. Previously, 3Com's model called for it to have 6 to 10 weeks of network interchange card (NIC) inventory, 8 to 12 weeks of modem inventory, and 8 to 12 weeks of network systems inventory. Now 3Com will run with only 4 to 6 weeks of NIC inventory, 6 to 8 weeks of modem inventory, and 5 to 7 weeks of network system inventory. The company will be able to do this because of extensive investment in electronic data interchange (EDI) systems linking 3Com with its channel partners. After this is complete, 3Com will have a much better idea of how much inventory is in the channel at any point, resulting in more predictable and linear sales.

Decreasing the amount of inventory in the sales channel (inventory held by retailers and distributors) will also make the company much more responsive to changes in technology. This quarter's revenues of $1.22 to $1.24 billion come in spite of the fact that the company has reduced inventory by three to five weeks, depending on the product lines. The company still needs to do even more on the modems and systems front, as it has 10 weeks and 9 weeks of inventory respectively. The good news is that in the second quarter sales out of the channel were higher than sales into the channel, meaning that the inventory was clearing out. By the fourth quarter, 3Com anticipates that volume into the channel will equal volume out of the channel and the lumpy sales will disappear.

3Com's decision to do this was exacerbated by the International Telecommunication Union's inability to resolve the standards issue for 56K modems and the Asian currency crisis that has caused growth in that region to come to a complete halt. Although the transition to 56K has been the fastest in modem history, uncertainty due to the absence of a standard has caused many to hold off purchasing the product. Currently the 56K market is only about one-third the size of the V.34 modem market. Although 3Com has dominant market share, slower-than-expected sales caused channel inventories to bulge. Add to this that the turmoil in Asia has turned 3Com's fastest growing market into its slowest growing market and you can see how inventory had an opportunity to pile up.

On the expense side, the company sees expenses being flat over the next three quarters as it benefits from the lower costs of its new inventory model. In a conference call, the company cited 10 key technology transitions it sees itself benefiting from over the next few years, stressing that the long-term picture for the industry still remains solid. Analysts seemed more tepid by and large, putting EPS estimates for the company in the $1.67 to $2.50 range for the next fiscal year. The average of the six estimate revisions issued today was $1.99 EPS, putting shares of 3Com at approximately 17.6 times these new forward estimates. If the company makes this estimate next year and trades at its current levels, it would still represent one of the lowest valuations for the company in this decade.


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