Fool Portfolio Report
Thursday, August 28, 1997
by Jeff Fischer (TMFJeff@aol.com)
ALEXANDRIA, VA (Aug. 28, 1997) -- In the past month the stock of 3COM (Nasdaq: COMS) has fallen 15%. Two weeks ago 3Com was downgraded on news that the current quarter appeared slower than anticipated and would be heavily back-end loaded if estimates were to be met. Adding fuel to the downside, on Monday an industry publication reported that the 56K modem standard, which was expected to be finalized by January, would likely be delayed. There are reportedly arguments regarding who owns key patents on the technology. 3Com and ASCEND COMMUNICATIONS (Nasdaq: ASND) fell on the news.
The fact that a potential delay of any kind shook investors out of these stocks indicates that some investors weren't very long-term. As stocks are only worth considering if you're investing for three to five years (ideally longer), even a substantial product delay shouldn't be enough to take an investor out of a well-researched and otherwise strong company. Perhaps the uncertainty regarding the industry does justify some re-evaluation.
The Fool bought 3Com over one year ago, and the stock is now flat from the purchase price. When the Fool paid $47.31 for 3Com shares last August, the company had a market cap of $7.8 billion, with $2.3 billion in trailing sales. It traded at a price-to-sales ratio of 3.3.
After merging with U.S. Robotics for nearly $7 billion at the end of May, 3Com's market cap is now $15.6 billion, and combined trailing sales are $5.6 billion. At $47 the stock trades at a price-to-sales ratio of 2.7 -- a ratio 18% lower than last year.
Last August the stock traded at 29 times trailing earnings. It now sells at about 27 times trailing earnings and 19 times the estimate of $2.43 per share (for the year ended next May). When the Fool bought 3Com, the estimated five-year annual growth rate was 31%. It's now virtually unchanged, at 30%. Trading at 19 times estimates, the stock looks about 50% undervalued if fair value is represented by a multiple close to the 30% growth rate. The YPEG value is $70 on the May estimate. ($2.34 x 30 = $70.20).
3Com's stock has remained flat and its valuation multiples have actually contracted over the past year, even as the company acquired the leading modem producer in the world. Most of us know the story. After doubling in value for the Fool, fear of competition from Intel sent 3Com lower, and then fear of an industry "slow-down" sent the stock lower still. Industry growth is likely slowing somewhat, but the fears were over-done. CISCO SYSTEMS (Nasdaq: CSCO) claims that the industry can continue to grow 25% to 35% annually for the next five years. Cisco beat earnings estimates and increased revenues 37% in the quarter reported early this month.
After the merger with U.S. Robotics, 3Com became the number one networking equipment seller in the world by product unit volume. But Cisco is indisputably the powerhouse of the industry, by both sales volume and market niche. The company has a vice-grip on the expensive router market, while 3Com is most known for selling inexpensive little network adapter cards (the company is working to increase sales of high-end products).
Even given the positions in which both companies currently operate, are the disparate stock valuations fair? Both companies have offered shareholders return on equity of 30%, and both are projected to grow earnings at around 30% annually over the next five years. Cisco is beating 3Com in the margin department -- largely because it sells the expensive products -- with operating margins of 30% compared to 3Com's 18%, and net profit margins averaging 16% compared to 3Com's 12%. But neither performance is anything to throw a mud pie at and boo off the stage.
Cisco's annualized revenues are on course to top $7 billion, and earnings per share of $2.61 are expected for fiscal 1998, ended next July. At $75, the stock trades at 29 times the current estimate. Adding together the last independent quarters of 3Com and U.S. Robotics ($829mm and $690mm in sales, respectively) we have revenues of $1.5 billion, and annualized revenues of $6 billion. Let's look at a few snapshots of information.
Income Statement 12-month sales: $6.44 billion 12-month income: $1.04 billion 12-month EPS: $1.52 Profit Margin: 16.3% Market Cap: $50.1 billion
3Com:Income Statement 12-month sales: $5.6 billion 12-month income: $597 million 12-month EPS: $1.69 Profit Margin: 11% Market Cap: $15.6 billion
Is it fair that Cisco trades at 7.7 times sales and 3Com at 2.8 times? That Cisco Systems trades at 29 times this year's estimate, and 3Com at 19 times?
If you believe that 3Com can not increase its high-end business -- that Cisco has the important networking market in the bag, and that 3Com is destined to commoditize itself under the pressure of its price-cutting competition -- then perhaps 3Com's discounted valuation compared to that of Cisco's is merited. But if 3Com, with U.S. Robotics, can keep leading the remote access market and move up the food-chain of higher-end products, gaining market-share, then the stock is probably undervalued.
Not even allowing for that success, but given only the growth rate of 3Com -- if estimates can be met -- the stock looks undervalued. The market still doesn't care for networking stocks (except for Cisco, apparently), but when investors do begin to care again, industry leaders will be the first to move closer to their historic multiples, and for 3Com that could mean a multiple much closer to the 30% growth rate, or 30 times estimates, rather than 19 times. Going forward, though, expect volatility, uncertainty -- and heck -- who knows what else. Especially if the questions surrounding 56K technology continue to abound. Tonight's evening news covers the topic well, especially in regards to Ascend Communications.
That mouthful aside, the Fool Portfolio lost 0.50% today while the S&P lost 1.10%. The gap grew smaller. ("Mind the Gap," as they say on the London Underground.)
To end on some unrelated news, Todd Etter (TMF Knave) sent along an article today from the Washington Post reporting that Fidelity is closing its flagship Magellan fund to new investors next month. The fund, at $63 billion, is "too large" to consistently keep pace with the market. Over most of this decade Magellan has lagged the S&P, especially as Jeffrey Vinik flipped in and out of stocks and loaded up on bonds, before taking leave. Due to restrictions regarding the maximum percentage of a public company that one fund can own, Magellan is "forced" to take positions in several hundred stocks. While the average mutual fund may own 50 to 100 stocks, Magellan has had to own up to 500 -- and even then the fund still had cash on the side.
Can you imagine trying to beat the market while owning 500 stocks? Most successful investors admit that truly great companies only number in the "handful" category. Once you move beyond that, you begin to reach a bit deep into the sandbox -- uncertain of what you'll find. Owning 500 stocks, of course Magellan can't steadily beat the market. The fund would have been better off this decade investing in the 500 companies that make up the S&P 500, and nothing more. Maybe they'll do so and call it the "Vanguard Magellan Fund"? That would certainly save on management expenses, and it would likely improve the fund's performance, indefinitely.
--- Jeff Fischer
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Stock Change Bid ---------------- AOL -1 1/4 64.25 T - 13/16 39.25 ATCT - 1/16 4.38 CHV - 7/8 79.06 DJT - 1/4 10.75 GM - 7/16 63.75 INVX -1 1/8 34.25 IOM + 1/16 25.88 KLAC +1 5/16 72.19 LU -1 5/8 79.00 MMM - 9/16 90.94 COMS --- 47.31Day Month Year History FOOL -0.50% 2.02% 17.91% 214.68% S&P: -1.10% -5.31% 21.99% 97.13% NASDAQ: -0.89% -0.78% 22.49% 119.57% Rec'd # Security In At Now Change 5/17/95 980 Iomega Cor 2.52 25.88 926.79% 8/5/94 355 AmOnline 7.27 64.25 783.77% 10/1/96 42 LucentTech 47.62 79.00 65.91% 8/24/95 130 KLA-Tencor 44.71 72.19 61.45% 8/11/95 125 Chevron 50.28 79.06 57.23% 8/12/96 110 Minn M&M 65.68 90.94 38.46% 6/26/97 325 Innovex 27.71 34.25 23.60% 8/12/96 280 Gen'l Moto 51.97 63.75 22.66% 8/13/96 250 3Com Corp. 46.86 47.31 0.97% 8/12/96 130 AT&T 39.58 39.25 -0.83% 4/30/97 -1170 *Trump* 8.47 10.75 -26.94% 10/22/96 600 ATC Comm. 22.94 4.38 -80.93% Rec'd # Security In At Value Change 5/17/95 980 Iomega Cor 2594.53 25357.50 $22762.97 8/5/94 355 AmOnline 2581.87 22808.75 $20226.88 8/11/95 125 Chevron 6285.61 9882.81 $3597.20 8/24/95 130 KLA-Tencor 5812.49 9384.38 $3571.89 8/12/96 280 Gen'l Moto 14552.49 17850.00 $3297.51 8/12/96 110 Minn M&M 7224.44 10003.13 $2778.69 6/26/97 325 Innovex 9005.62 11131.25 $2125.63 10/1/96 42 LucentTech 1999.88 3318.00 $1318.12 8/13/96 250 3Com Corp. 11714.99 11828.13 $113.14 8/12/96 130 AT&T 5145.11 5102.50 -$42.61 4/30/97 -1170*Trump* -9908.50 -12577.50 -$2669.00 10/22/96 600 ATC Comm. 13761.50 2625.00-$11136.50 CASH $40625.59 TOTAL $157339.53