By Paul Larson (TMF Parlay)
February 28, 2000

3Com Inc.
Ticker: (Nasdaq: COMS)
Phone: 408-326-5000
Website: www.3com.com
Price (2/25/00): $80 11/16

How Did It Double?
After being one of the stars of the early '90s in the computing and networking worlds, 3Com had fallen on hard times. The market for many of its networking products took a slight dip, tarnishing gross margins. Add to this a major merger with U.S. Robotics that was not easy to digest, and 3Com found its sales growth essentially go to nil. With the anemic financials, it is little surprise that 3Com had fallen out of Wall Street's favor.

But now, 3Com is back with a vengeance. After bottoming out at $20 a share this past April, in the last few days 3Com made new all-time highs above $80, just eclipsing the mark the company had achieved before its troubles began in late 1996.

The recovery has been driven by two major factors. First, the company's core financials have started to look slightly better in recent quarters. By focusing on cutting costs, 3Com has managed to grow its operating income for three straight quarters. Revenue growth as a whole is still flat-lining, but the company's bottom line remains black.

The second force driving 3Com's stock is certainly the more relevant of the two factors. Back in September, 3Com announced that it intended to spin off its Palm (Nasdaq: PALM) computing division, maker of the popular Palm Pilot handheld computer. Palm should be coming public sometime this week.

The results from Palm have been significantly better than those of the rest of 3Com, with sales tracking at near a 70% annual growth rate. More importantly, estimates show the Palm Operating System running anywhere from 60-80% of all the handheld computers, giving the system critical mass and a competitive position that will be very difficult to crack.

The Palm computing business is seen as highly attractive by many investors, and many of these same investors have purchased 3Com in anticipation of the eventual distribution of Palm shares to 3Com shareholders. In short, 3Com has seen its stock price more than double, and today, shareholders have seen the number of public companies under 3Com's control also double.

Business Description
3Com, short for "computer, communication, and compatibility," is the nation's second-largest producer of computer networking products behind only industry titan Cisco Systems (Nasdaq: CSCO).

3Com runs three distinct business units. The company's personal connectivity business focuses on the modems and network cards that link computers to private networks and the Internet. The second business line, network systems, makes hubs, switches, and routers as well as the software to manage all these crucial network pieces.

In 1997 3Com bought what was then the nation's leading modem maker, U.S. Robotics. Through the Robotics purchase, 3Com acquired its third major line of business, and certainly its most attractive today, in Palm Computing. Palm is in the process of being spun off from 3Com. 3Com is only selling about 8% of Palm in this week's IPO, and plans to spin off the balance of the shares to 3Com shareholders in approximately six months.

Financial Facts

Income Statement
12-month sales: $5,688.5 million
12-month income: $492.1 million
12-month EPS: $1.36
Profit Margin: 8.7%
Market Cap: $28158.3 million (348.988M diluted shares)

Balance Sheet (as of 11/26/99)
Cash and equivalents: $2,011.5 million
Current Assets: $3,998.4 million
Current Liabilities: $1393.2 million
Long-term Debt: $16.5 million

Ratios
Price-to-earnings: 59.3
Price-to-sales: 4.95

How Could You Have Found This Double?
One of the ways to have perhaps been alerted that things were looking up at 3Com was to have noticed that the company started repurchasing shares back when the stock was near its low. While share buybacks are not nearly as strong a "buy" signal as outright insider purchases, they are still an indication that the company's management thinks that its shares are undervalued.

Then, of course, there is the Palm IPO. 3Com announced back in September that it intended to spin off the Palm business to its shareholders, and the stock held its ground near $30 a share for at least a month after the announcement was made, giving those true believers in Palm more than enough opportunity to buy long before the masses started jumping into the stock.

Back on January 28, an amended S-1 registration statement was filed with the SEC showing that Palm intended to offer its IPO shares at as much as $16 per share. If the shares were sold at that price, that would give Palm a market capitalization of $9.1 billion, which was more than half of 3Com's total capitalization of close to $17 billion at the time. That's fairly impressive since Palm only accounted for just over 15% of 3Com's total sales so far this fiscal year.

Where to From Here?
Where 3Com will go in the next 6 months depends quite a bit on where Palm goes. Without a doubt, the shares of the two stocks will move in synchronization with each other until the rest of the Palm shares are distributed to 3Com shareholders. Looking at what numbers are available today, it appears that each 3Com shareholder could get approximately 1.5 shares of Palm Computing for each 3Com share they own.

The future for Palm does look quite bright. The company's operating system runs a majority of the handheld computing devices in existence, which is a significant and sustainable competitive advantage. Numerous other companies have joined forces around the Palm platform including such heavies as America Online (NYSE: AOL), Sony (NYSE: SNE), Motorola (NYSE: MOT) and Nokia (NYSE: NOK). Consumers are choosing the devices that have the most applications, and both software and hardware developers are making products that are most popular with consumers. In other words, the Palm platform is quickly becoming the standard operating system in the handheld computing space.

One of the reasons the Palm platform is so popular is because Palm has licensed the operating system to other handheld computer makers. The most notable of these is Handspring, which is a company recently started by the original founders of Palm. If you think Palm Pilots are popular, just try getting your hands on one of Handspring's Visors. Either way, Palm is in a great position to focus on and profit from the Palm platform's software and related services.

But what about 3Com's networking operations? 3Com will now be concentrated on its core business, which is still quite anemic. However, this business remains quite large and profitable with annual sales tracking near $6 billion and earnings of about $500 million expected next year. Putting a 20x earnings multiple on the networking businesses gives us a back-of-the-envelope value of $10 billion. Of course, this Palm spin-off could be just what the doctor ordered to reinvigorate 3Com and get earnings growth back on track.

Either way, the next couple months will find investors playing the arbitrage game by estimating a value for 3Com's core business and then adding to it the value of the newly public Palm Inc. The two companies will surely be interesting to watch as each plays its new hand.

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