By Debora Tidwell (TMF Debit)
ALEXANDRIA, VA (September 24, 1997)/FOOLWIRE/ --- 3Com Corporation was pleased to report record revenues and improvements in their financial performance for the first quarter of operations of the new 3Com following their merger with US Robotics. The company started their analyst conference call by reading the press release for their first quarter 1998 financial results. As it was read verbatim and is available through 3Com's web site, we are not repeating it here.
THREE KEY MESSAGES. They wanted to convey 3 key messages. First, the merger is on track and off to a great start. Clearly it is still early in the process. They still have an enormous amount of work to do. But, they are beginning to see the expected benefits of this combination, both internally and externally in the marketplace. Second, their industry is continuing its growth along the anticipated trajectory. When many analysts were in Santa Clara last July, 3Com chairman Eric Benhamou outlined the major trends they think are shaping the industry. They all seem to be playing out as anticipated. Third, 3Com is beginning an exciting new product cycle that will drive their growth in marketshare gains in the second half of the fiscal year and beyond. This new product cycle extends across almost all parts of the business and is expected to reach a crescendo in the Winter timeframe.
SYNERGY OPPORTUNITIES. They approached their merger with US Robotics with a long list of synergy opportunities, but also with a keen awareness of the risks and difficulties associated with large transactions. They decided early on that it was essential that they become one company as quickly as possible and set an agressive timetable for the changes and decisions that had to be made to reach that goal. They believe they made the right calls and that the merger is on track.
ORGANIZATIONAL STRUCTURE. Their business units organizational structure announced in April and implemented on June 12 is working well. It strengthens the focus they need to place on each of their markets and allowed cross-organization collaboration necessary to their system strategy and will enable them to scale 3Com to the $10 billion level and beyond. They have completed the integration of their sales forces by channel and by geography. They have completed plans to rationalize their product strategy, their branding strategy, their manufacturing plants, their office facilities and have started their implementation.
CULTURAL DIFFERENCES NOT A PROBLEM. The cultural differences between the two organizations which competitors were hoping would be an impediment to their success have not diverted their attention from the business nor introduced dysfunction in the management team. Instead they are proving to be a new competitive asset. In addition, some early benefits of the merger are beginning to be visible, particularly in the field of strategic partnerships. For example, the establishment of a broad relationship with Siemens involving network integration of all 3Com products, joint developments in LAN-based telephony and also in voiceover IP. Similarly, their relationship with IBM became deeper and broader this quarter, covering joint developments of next-generation ATM technology, integration of 3Com's tactical switches into IBM's network product offering, expansion of IBM's global network with Total Control and x2 technology, and finally the integration of their PalmPilot platform under the brand IBM WorkPad PC Companion into IBM's PC product line.
EXPANDED RELATIONSHIPS. They expanded their pre-existing relationships with Dell and with Gateway 2000, both based on 3Com's LAN technologies to include 3Com's modem technologies. In the category of technology partnerships they expanded their relationships with several companies like Picturetel to reflect 3Com's broader product capabilities across both LANs and WANs.
Finally, the majority of the top 25 enterprise accounts is now evaluating or has begun deploying remote access solutions based on 3Com's Total Control platform. In general, the stature of 3Com has risen dramatically in the marketplace, which makes it easier and more natural for their sales force to be invited to participate in virtually every large networking project or industry event around the world. Obviously they still have an immense amount of work to do before they can declare the merger is behind them. They must address the many operational inefficiencies. This will take them several more quarters, but they feel more confident today of their ability to tackle them successfully.
KEY INDUSTRY TRENDS. Overall, they find industry growth rates to be consistent with the rates they discussed last July. The PC industry growth rate is now in the high teens. The network infrastructure industry growth rate remains in the 30-50% range while the applied access growth rate is roughly midway between the PC industry and the network infrastructure industry. Although year-over-year growth rates are continuing to come down as has been the case for the past several quarters, sequential growth rates are now on the rise again, reflecting the fact that, after a very strong 1996 year, their industry experienced a sharp deceleration last Winter but began recovering in the past few months as anticipated.
MAJOR GROWTH FACTORS. The major growth factors fall into four categories. One, enterprises are deploying infrastructures to support their intranets and extranet plans as well as their new client/server applications. Increasingly, these networks are becoming fully switched infrastructures, although the transition from shared to switched medium is far from over and will remain a key driver of 3Com's growth over the next few years. With desktops moving to fast Ethernet speeds and backbones moving to ATM, OC3 and OC12 as well as gigabit Ethernet.
Two, enterprise is also eager to extend network services to customers, partners, and remote employees. They are deploying remote access concentrators. Increasingly they are currently subcontracting this service to carriers and ISPs, but soon there will be interest in virtual private networks.
Three, in preparation for new applications, particularly those that will require high bandwith, secure flows, or heavy multimedia content, customers are now eager to create intelligent network infrastructures. The integration of voice, video, and data; the addition of security capabilities; the integration of global directory services are examples of the sort of intelligence that characterizes new networks for new applications.
Four, finally small business customers and consumers are continuing to emerge as new high-growth markets, demanding even more simplicity, better standards, more complete solutions, and better support. As a result of these various customer trends, product segments such as switching, remote access, fast Ethernet connections, and connected organizers are enjoying the strongest growth rates.
MODEM MARKET. The modem market is growing more moderately as the industry's failure to reach standards for 56K transmission has postponed the broad upgrade cycle from the v.34 standard by a few months. They now expect the IPU to make more rapid progress soon and to identify a draft standard at or before its next January meeting.
COMPETITIVE ENVIRONMENT. Competitively, 3Com continues to encounter Cisco more and more as they increase their penetration of the enterprise market. 3Com is pleased to see their major account base continue to expand with important new account wins such as the Federal Reserve Bank, and Morgan Stanley Europe. This past quarter they moved from a close number 3 in the systems business to a clear number 2. Ascend is their most common competitor in the remote access/ISP market but they don't seem to be as well entrenched as they once were and 3Com is making major inroads into accounts like PSI and also international ISPs where Ascend once was very strong. Intel and their partner Zircom are now 3Com's chief competitors left in NICs and their chief competitor in modems remains Rockwell.
PRICING ENVIRONMENT. The pricing environment has been fairly predictable over the past few months across most segments while remaining very competitive. NICs and modems are on the traditional curves. Remote access ports have come down in prices more rapidly than in the past as a result of density increases and router ports are beginning to receive a frontal attack from much less expensive layer 3 switches that cover equivalent functionality and better performance, at least in LAN configurations. While ASP erosion clearly continues and competition remains intense, they have not seen the type of price dislocation that they experienced in parts of their business last Winter.
STRONG NEW PRODUCT CYCLE. They are beginning a strong new product cycle across virtually their entire business. In the latter part of the last fiscal year, with the exception of their x2 technology, most of the new products introduced during that period were evolutionary expansions of platforms or product lines already in existence. 3Com is now beginning a more radical overhaul of their portfolio based on a new generation of ASICs, breakthrough platforms, and also major additions to their software family. Over the balance of the calendar year they also expect to begin shipments of their single chip fast Ethernet NICs, their fast IP technology introduced earlier this year, and have a high-performance chassis-based CoreBuilder 9000 for gigabit and ATM data center applications. While most of these new products have already been introduced, they will drive revenue and profit growth in the second half of the fiscal year and beyond.
WHAT'S INCLUDED AND WHERE. Q1 1998 was their first combined quarter with US Robotics and includes the months of June, July, and August. Q4 of 1997 combines the quarters ended in May for heritage 3Com and March for heritage US Robotics. US Robotics results for April and May will be summarized as an adjustment to retained earnings to start the fiscal year.
SALES, PRO FORMA EARNINGS AND INCOME GROWTH. 3Com started the year on an up note with sequential growth in both sales, up 6%, and pro forma earnings and income, up 8% with earnings per share up 7%. They saw growth in both their systems (up 7% sequentially) and client access (up 6%) businesses which grew primarily through market share gains in several key product areas including hubs, switches, adaptors, and modems.
FINANCIAL MODEL GIVEN TO ANALYSTS. In July they detailed a long-term financial model for the company calling for gross margins in the range of 48-50%, expenses as a percentage of sales between 30-32%, and operating income at 16-20%. Their Q1 results are in the relative ranges but at the lower end. They continue to believe that they can and will make progress at improving their financial model over the remainder of the fiscal year. The pace at which they achieve improvement will be driven by their ability to improve channel inventories, execute their merger synergy opportunities, and the acceptance of their new products.
SALES. Sales for the quarter were $1.6 billion, a 28% increase from the year-ago quarter and up 6% sequentially. Given that this is the first quarter reporting results for the combined company, they reminded that the breakdown of sales by product line is in two categories, systems and client access. Systems include hubs, switches, internetworking and remote access products and client access consists of modems and adaptors. The breakdown is as follows: systems sales totalled $714 million, it was 45% of the total, up 7% sequentially, and up 34% over the same quarter a year ago; client access products totaled $886.8 million, were 55% of the total, up 6% sequentially, and up 23% over the same quarter a year ago. Their systems business showed good growth with continued growth in demand for both switches and hubs. Enterprise remote access as well as broadband and ATM access products also contributed positively to the sequential growth rate. Sales of traditional core internetworking products were less robust, in part because the market continues to move to switching. The client access business showed nice growth in Q1 reflecting marketshare gains in several key categories and continued product mix shifts as the transition to higher speed technology and mobile platforms accelerates. One of the fastest growing product segments in the company is the PalmPilot connected organizer which continues to enjoy tremendous acceptance.
SALES BY GEOGRAPHY. Sales in the US were $886.7 million, 55% of the mix, up 7% sequentially, and up 15% year-over-year. International sales were $714.1 million, 45% of the total, up 5% sequentially, and up 49% over the same quarter a year ago.
GROSS MARGINS. Gross margins declined in Q1 to 48%, down 1.3% from 49.3% in the previous quarter. Last quarter's gross margins included the introductory shipments of x2 modems which generated higher gross margins than was believed sustainable in desktop modems. The decrease in gross margins also reflected continued aggressive pricing in some product categories and the aforementioned transition to higher speed technologies which tend to carry lower gross margins.
EXPENSES. Expenses grew less than 2% in absolute dollars from Q4 and as a percentage of sales expenses were down 1.4% sequentially to 31.6%. A major driver of the reduction in expenses as a percentage of sales was headcount, which declined by 369 from the end of the previous fiscal year and now totals 13,270.
INCOME. Pro forma operating income improved slightly from the prior quarter, up 0.2% to 16.4%, as the reduction in expenses as a percentage of sales more than offset the reduction in gross margins. Other income for the quarter was $3 million. This figure was adversely impacted by foreign currency exposures by approximately $3 million. Their currency exposures are relatively small as many of their foreign sales are in dollars. However, they do have some sales in local currencies. This quarter saw many currencies fluctuate fairly significantly against the dollar. While they attempt to hedge revaluation gains and losses, this exercise is imprecise at best.
TAXES, SHARE COUNT, EPS. The pro forma tax rate for Q1 and fiscal year 1998 is 35%. This is a little below the 35.5% rate they spoke about at the annual analyst meeting as changes in tax laws enacted at the end of July had a positive impact on their rate. The absolute number of shares outstanding at quarter end was 345.9 million, an increase of 11.4 million from the prior quarter. The pro forma weighted average share count used to compute the pro forma EPS of $0.48 was 361.1 million. Pro forma earnings per share for the quarter was $0.48, up from $0.45 in the previous quarter, a 7% sequential growth rate. Including the one-time merger related charge of $426 million, EPS was a loss of $0.43 per share.
MERGER RESERVE. The merger related reserve reflected in the Q1 results was higher by approximately $50 million, in the upper end of the range previously estimated. There were two primary reasons for this. One was an increase in the reserve related to severance cost. This resulted in an increase in reserves of approximately $35 million. Second, they pinned down the amount of exposure related to inventory purchase commitments and on discontinued products and increased reserves share by about $20 million. There were a few minor ups and downs but these were the two significant changes from the estimates made last Spring.
ASSET PICTURE. Their key balance sheet metrics all improved during the quarter. Cash and investments grew by almost $70 million to over $1 billion. Receivables days sales outstanding decreased from 74 to 64 days, a 10-day improvement sequentially, and the absolute amount of receivables declined by almost $100 million. To be fair, this metric was positively impacted by a 5-month collection period inherited as USR. But, even without that, they suspect DSOs would have come down by several days. They are not yet certain whether the DSO number from Q1 is sustainable in the short term, but directionally they can certainly see progress. Inventory levels grew 2% and as a result inventory turns improved to 8.2 from 7.5 in the previous quarter. This metric is at or near an all-time high, at least for heritage 3Com. If anything, when inventory turns get this high they worry about stock "outs."
DEBT PICTURE. They reduced long-term debt by $10 million and paid off all the short term revolvers and credit lines in place at heritage USR, totalling $60 million at last quarter end. The single biggest item left in the long-term debt component is the $110 million convertible debenture issued in November of 1994. It is callable on its 3-year anniversary this Fall. It is likely that this debt will convert to equity some time between November and next April, the date of the next interest payment.
LOOKING FORWARD - CHALLENGES. Looking forward, on the challenges side channel inventory is an item that could impact results. They don't have perfect data here and are working to expand the data they do collect. Their channel inventory targets vary by product line, by channel, by geography, by season, and by competitive positioning. In general, these targets reflect a band of about 4 weeks, plus or minus two weeks. Where they have the best data is North America. This data shows that inventory levels remain near the upper end of the preferred range. They have less comprehensive data, actually very little systematic data, to assess inventories outside the US, but suspect their levels may be modestly higher there than in the US. This was the most difficult quarter from an accounting perspective due to the merger and related integration processes. This will get better, but will not be at the 3Com standard for quite some time. In the next several quarters they will introduce a string of significant new products. They will have to conduct a successful transition with their channel partners as these products begin shipping. As they entered the year they expected to be shipping a cost-reduced version of their fast Ethernet adaptors in Q2. This product is now scheduled to ship in Q3.
LOOKING FORWARD - OPPORTUNITIES. On the opportunity side, they have a strong new product cycle, particularly in systems. Probably the biggest suite of new products ever introduced by 3Com are arriving in the balance of this fiscal year. They continue to make good progress on synergies related to the merger and they expect they will continue to find synergies going forward which is one of the reasons they are optimistic about their chances to improve their financial model. They have a strong leadership position both for key product segments and in the channels of distribution. The company will hold its annual shareholders meeting on October 7th.
* 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. Note: Statements made by a company other than historical information may constitute forward-looking statements for which the company can claim protection under the Safe Harbor Act. Please consult the company's filings with the SEC for information on risk factors which might cause actual results to differ materially from the information contained in these forward-looking statements.