Rule Breaker Portfolio
Fool Buys 3Com
August 13, 1996

3Com Inc. (NASDAQ: COMS)
Type: Large-Cap Growth
Phone: (408) 764-5000
Closing Prices, August 12th, 1996: Bid $45 7/8 Ask: $46 1/8

Trailing 12-month revenues: $2.3 billion
Trailing 12-month EPS: $1.62
Last quarter reported: May, 1996 (FY: May)
Next quarter reported date: 1Q, September 18, 1996
Consensus EPS estimates for quarter: $0.50e vs. $0.38

FOOL ratio: n/a

FOOL YPEG: 0.66

---->Trade: Buying 250 shares

INTRODUCTION

3Com is a leading provider of data-networking equipment and services to a broad line of corporate and consumer partners. The company is engaged in building out infrastructures for local- and wide-area networks designed for the rapid transmission of electronic data. What are the "three coms"in 3Com? Computer, communication, and compatibility -- each essential to furious growth in data networking and interactive services, and all that they entail.

At present, 3Com is in a dogfight with competitors, depending on the product front. The two largest challengers are familiar names to any technology investor. In adapter cards and Ethernet switches, 3Com finds itself struggling with Intel Corporation. In switching technology, COMS is battling with the Boring Portfolio's very own Cisco Systems (cf. The Hall Of Portfolios).

Fundamental to 3Com's strategy going forward, and a feature we're much enamored of, is the company's stated goal to continue providing products and services both to giant conglomerates and to the small businesses and individual users linking to local-area networks and the Internet.

To illustrate that point, consider the company's investment in stamping its corporate identity on Candlestick Park in a deal that extends through the year 2000 (cf. The 3Com Ballpark Web Site). Ever wonder what happens when you drop a slew of mustard, relish and onion on a Fast Ethernet switch? Risking just that, 3Com has thrown up kiosks in the park to display their networking products to all those people sauntering by with Joe Montana (blech) pullovers. If you believe that in a decade networked computers will dominate our world -- from communications to education to entertainment -- then you ought to take a look at 3Com's business. They're reaching to meet all customers.

On the numbers side, COMS is capitalized at $7.8 billion, with trailing sales of $2.3 billion, 12.5% profit margins, a large cash position, and modest debt obligations. The valuation is resting on trailing earnings per share of $1.62 and estimates two years forward for $2.96. To our eyes, 3Com looks undervalued here at $47 a share.

But before we dig down into valuing this stalwart, newcomers to the computer networking industry must take a minute to read through our friendly overview of the networking industry provided by MFs MOM and Networx (keyword: FoolNet):Foolish Networking Overview. (For future reference, this outstanding feature is located in our Stock Research section, under Networking.)

THE BUSINESS

"So," you ask, "what in the heck is all this networking talk all about? Seems like a lot of acronyms, very little consumer appeal, and a competitive landscape in which I have no real interest." Indeed, a look at COMS's product guide turns up Fast Ethernet Cards, Tranceiver Interface Modules, Remote Access Routers. . . gasp!

Let's first nail down some of the definitions doled out on the the 3Com web page, from the bottom up:

The adapter card is installed in your PC to provide a network connection.

The hub is a device that then connects several PCs in a group to one another.

The switch is a device that links several groups of PCs to the central network.

The router is a device that connects networks in different locations.

Voila!

3Com has positioned itself as a one-stop shop for networking products, consulting, and services. As businesses develop, COMS can be involved in every level of their expansion. For example:

OK, let's make up a small hypothetical business and call it Bass CookWare. Bass CookWare bundles software with the appropriate cooking utensils for home chefs. Now, the first thing that Bass's chief technological officer would need to do for his programming unit would be link their computers on a single floor of an office. As the employee base grew and the company co-opted the entire office building, they'd link together the computers on all four floors. Later, the move to sell applications into all fifty states, demanding an increase in local business and marketing staff, would require them to hook up all of the buildings on their corporate cooking campus. Next, with annual revenues above $500 million, they would begin linking in additional corporate offices from across the nation and the globe. And then they pay $118 million to acquire Hal's Hungry Huts in Houston, so it's time to link Hungry Hut headquarters into the mother network. Finally, let's build into the network each of Hal's 137 late-night gourmet snackhuts across the nation.

Of course, as networking power expands, the data that Bass CookWare exchanges with its staff -- shifting from one desktop to the next, from network to network, from Zimbabwe to Rome to Venice, California -- will rapidly evolve. It'll begin with simple e-mail and file transfers -- communication between employees, moving contracts around, sharing individual Hungry Hut financial statements. Then they'll upgrade to graphical transfers (marketing materials), then audio transmission (voice messaging), then full-motion video (the CEO's message to Bass employees), then interactive video conferencing (everyone stops working forever and just gabs with all these other people across the planet).

To establish itself as a major player in the construction of this infrastructure and the myriad businesses it entails, 3Com has been both on the acquisition trail and actively seeking design and marketing partners. On 3Com's partner list sit Ascend Communications, AT&T, Dell Computers, IBM, Microsoft, Oracle, SunMicrosystems, et al. In acquisitions 3Com bought Axon Networks, a network traffic management business, for $65 million in March. In July of last year, 3Com acquired Chipcom, a switching business -- quiz answer: switches link groups of PCs to the central network -- for nearly $800 million.

Healthy growth by all means possible.

THE FINANCIAL SIDE

In fact, the sales and earnings have grown so heartily that the biggest fear for the group is that the leading providers -- Cisco and 3Com -- have broadcast too loudly to the technology giants -- Intel and Compaq -- that they'd be extremely foolish (small "f," of course) not to participate in these markets. But they may have enough running room already.

In its 4Q 1996 (fiscal year ended 5/96), COMS announced $660 million in sales, and earnings per share (EPS) of 45 cents -- one penny below Street expectations -- on 10%+ profit margins. Business growth was most rapid in the US and Asia, and the revenues breakdown shows a 50/50 split between domestic and international sales today.

3Com now has $500 million in cash versus $110 million in long-term debt, and $1.2 billion in current assets versus $414 million in current liabilities. Not bad at all. Gross margins are running in the 52%-53% range. And the company continues to spend fully 10% of its revenues on research and development.

The business is in outstanding financial shape and the prospects for companies integral to the buildout of networking infrastructure are shiny.

THE STOCK'S PERFORMANCE

3Com stock has been a dream investment over the past five years, compounding annual growth in excess of 80% per year. Take a look at 3Com's stock chart (adjusted for splits) dating back to 1989, courtesy of Quote.com ( 3Com: 7-Year Chart ). It's a thing of beauty, no? Such is life for the companies that pursue growth at the right price.

But, hey, past performance is no guarantee of future results... and don't The Fool know it! Applied Materials has proven one of the greatest investments in our nation over the past decade, and yet (pow!) we managed to lose over 40% of our position in AMAT. And fast.

Will the same happen with COMS?

It could. Networking is an extremely competitive business today. Intel announced a new Ethernet Switch in mid-March and (sock!) COMS traded down nearly 10% lickety-split. Compaq announced across-the-board price cuts on its networking equipment and (crunch!) the stock doled back a quick couple bucks. Computer networking's rapid growth and fat profit margins have invited competitors in all shapes and sizes and with a wide variety of intentions.

But 3Com has held its own technologically and financially, and maintained its second-place networking position behind Cisco Systems, one of the primary reasons we're hopping aboard this week. The battle to provide the best networking infrastructure will rage on, and we recognize that there are no guarantees here; however, with $2.3 billion in sales, healthy double-digit profit margins, and a stated objective to provide networking services to a broad base of customers, 3Com looks awfully well-positioned to us.

PROSPECTS

A month ago, Morgan Stanley upgraded the 3Com to Outperform, recommending its stock for purchase and setting a 12-month price target of $65. We'll do just about the same, short of actually recommending that you purchase this stock. That's not our game. Oh, and by the way, Dave and I don't make a market in this stock. Likewise, we did not underwrite their initial public offering, nor have we done any financing work for 3Com. Someday, maybe -- in the Foolish business plan, we have that slated for 2037 AD. For now, we're merely lowly Foolish individual investors.

As always, we announce our intentions to make investments in advance of doing so and report back exactly how our investments have done -- after the deduction of transaction costs, and always relative to overall market growth. We've set this up to resist that nasty habit of frontrunning to which so many public portfolios seem to have succumbed. And we've also structured our transaction policy so that you might, if you so choose, duplicate the performance of The Fool Portfolio.

(Do we think it reasonable that you do just that? Reasonable, but not as fun. Hey, in that we expect to squash the market's returns over the next three decades via diligent, fundamental research, sure. Do we make performance guarantees? Nope. Do we think you should do your own investigative work, regardless of whether you buy, sell, or short a Fool Portfolio stock? Absolutely, yes. And it's always our earnest hope that our readers are continuing to learn from Fooldom, and so increasingly don't even need to listen to us Fools with our new trade announcements... much more fun to do it on your own. Anyway....)

Ok, now to our Foolish ratios.

With $2.3 billion in highly profitable sales, 3Com cannot and should not be evaluated with the traditional Fool Ratio (PEG). We prefer to use PEGs with small-cap growth stocks, as we've always stated... using the PEG can be too conservative for ten-ton gorillas because they'll generally look "overpriced" and cause you to miss some great stocks.

Rather, we look at the so-called (yeah, we hate these acronyms too) "YPEG" which just multiplies a company's estimated long-term growth rate by its year-forward EPS figures. (You can get an overview of YPEG and other PEG variants via the How to Value Stocks section of our Stock Research department -- look under the Fool Ratio section.)

In COMS's case, the annual growth rate is 31% and projected EPS numbers are $2.30. That targets the stock at $71 a share, six dollars above the Morgan Stanley quintain.

If COMS meets these estimates in the year ahead, the YPEG fair price 12 months out will sit above $90 a share, marking the potential for a Foolish double by this time next year. With burgeoning cash flows, an eye on marketing itself to more than just other giant businesses, and with minimal debt obligations and robust bottom-line margins, and finally, with our nation's and the globe's hunger for higher networking capacity, greater reliability and faster access, 3Com looks attractive to us.

Folly, of course, demands that you make your own investment decisions and that you use this research work as a jumping off point for your own analyses. To that end, we provide you again with the company phone number: (408) 765-5000.

Dial these guys up and get their financial package sent. Additionally, at the company Web page (http://www.3com.com) you can score more information about Les Trois Commes's products, management team, and visions for profitable growth.

Please note that we'll be putting approximately 9% of our assets in this new stock. This is in keeping with the effort to balance our runaway portfolio's allocation; this is just as you should buy increasingly larger dollar amounts of new stocks as your portfolio rises steadily over time. The important thing is to note the percentage of your overall pie you're putting in a new stock. We never put more than 15% of our portfolio into any new investment, and don't recommend you do so, either.

Finally, Foolish portfolio policy dictates that we will make this move at any point during the next five market trading days. Thus, this may or may not occur tomorrow (same with our Gap sell).

Can't wait to see what the year ahead brings for this networking giant! Fool on.

-- Tom Gardner