Fool Portfolio Report
Tuesday, February 4, 1997
by Jeff Fischer (MF BudFox)

ALEXANDRIA, VA., February 4, 1997 -- 3Com was hit in the head by a brick a few weeks ago and has been stumbling about ever since. In the movies, often a note is attached to the brick by a rubber-band. At the time of this crime, though, no such luck for our boy 3Com. This was a drive-by bricking and nobody knows who threw that first brick. Our beloved Trois Com was smacked square in the face by an anonymous brick -- in fact, an invisible brick. Pow!

Ouch. Busted nose.

Now more bricks have been thrown. Our stock has fallen 25% in one month. Last week some analysts cut estimates by pennies here and there after 3Com said December sales were slower than expected, but hinted that January was making up for it. Otherwise, only good news has continued to roll out of Santa Clara, including four healthy press releases today; but the stock continues to fall.

Today 3Com fell as an analyst at Deutsche Morgan Grenfell, Noel Lindsay, cut his quarterly earnings estimate from $0.63 to $0.58 per share, and lowered his fiscal year estimate from $2.41 per share to $2.34. He sliced estimated revenues for next quarter from $875mm to $850mm. The stock fell $3 3/4 on massive volume of 24.8 million shares. Over-reaction? The analyst lowered his estimated revenues for the fiscal year to $3.31 billion from $3.36 billion -- not a notable amount -- in fact, perhaps even less than the room often granted for margin of error with such estimates.

There wasn't mention of any new reasoning behind the analyst's statement aside from the old news that 3Com experienced a slowdown in indirect sales channels during December, which was described as a "one-time anomaly." Meanwhile, the analyst reiterated his "buy" rating on the stock.

Given the lack of earth-shattering news, the stock has fallen so rapidly and mysteriously that many 3Com investors may begin to feel like a character in a Kafka novel: everyone knows something is going on, except for you. Frightening thought. Soon, some investors may find the urge to follow the crowd: "Heck, if they're all selling, I better sell, too. 3Com, a world leading company, out of my portfolio, jettisoned! because that's what the market is doing." Ouch.

Networking: if you look at a chart of the industry's growth over the past decade you see a dream of a sector in which to invest. But has it peaked or is it notably slowing? You tell me. A leading company like AMERICA ONLINE (NYSE: AOL) has daily member usage double to only 32 minutes per day and the company's network is shot to hell. More than half the people can't get online, and when they can, the network is often slow. AOL needs to build out their network to not only meet current demand, but that of future demand, too. But that's just one company.

Ironically, while networking stocks fell today, IDC Research released 1996 year-end summaries for key networking products. Growth is the theme. The big theme. Reports can be seen on IDC's Web site.

One headline stands out: "Unprecedented Growth in Global Internet and World Wide Web Usage." The article states:

•The number of devices accessing the Web will grow from 12.6 million worldwide at yearend 1995 to 233.3 million at yearend 2000.

•The number of users accessing the Web will grow from 16.1 millionat yearend 1995 to 163.0 million at yearend 2000.

The Internet reaches about 10% of homes in the U.S., while Europe and the rest of the world lags well behind. Meanwhile, Intranets are a new world. A scant percentage of corporate America has them in place, but the business is estimated to grow from $2 billion last year to around $14 billion by 1999. That's a conservative estimate.

Networking is the column supporting the build-up of a technology which is arguably in the position to replace the television, as computers can replicate television -- while offering so much more. ''The Internet and intranet are the most significant events in computing since the invention of the Personal Computer,'' stated Intel Corporation (Nasdaq: INTC) last year. Down the road, if you're not networked, you're going to be out of the loop, isolated. And being "networked" promises to become a much "smaller" -- and so increasingly omnipresent -- way of life, as Bill Gates foresees the Internet in your pocket.

We'll become so well-networked in the next few decades that you'll be able to reach into your pocket, pull out a contraption, log onto a network and see your mom's face smiling at you from five thousand miles away, while on the split screen you're surfing the Web for a recipe to send to her through a fax button. Simultaneously, CNN on the Web is playing on the other side of the screen, and your flight confirmation number is sitting at the bottom of the screen, along with a proposal just sent to you from your Asian business partner, with a live line set up for you to talk to him or her immediately. Just click that icon. Seven things at once.

Despite the future, 3Com and some others in the networking sector have taken a bath. In a mere month, since January 6th, this has happened with some industry stocks:

Ascend Comm (Nasdaq: ASND) Up 6.4%

Cisco Systems (Nasdaq: CSCO) Flat

3Com Corp (Nasdaq: COMS) Down 25%

Cabletron (NYSE: CS) Down 3%

Cascade (Nasdaq: CSCC) Down 34%

Shiva (Nasdaq: SHVA) Down 50%

US Robotics (Nasdaq: USRX) Down 9%

Bay Networks (NYSE: BAY) Flat

3Com is one of the more bruised stocks, though not the hardest hit. Cascade Communications was slammed after reporting earnings which many companies would be proud to share. The fear was slowing sequential growth, and Cascade and Shiva spooked the networking sector as a whole. 3Com appears to be the stock hit hardest for the least reason, though. "Loss" to "Reason For Loss" appears out of whack with 3Com. So is this good old fashioned panic at this point with the stock? If so, those people selling the stock are selling directly against the current of one of the most important and largest advances in technology to come in decades. And they've got to be selling the future of networking at a cheap price.

Let's look at some of the numbers behind the names:

Ascend Communications ($66)
Five year est. annual growth rate: 45%
Far earnings estimate: $2.01/share
P/E on estimate: 33
Net margins: 23%

Cisco Systems ($67)
Five year est. annual growth rate: 35%
Far earnings estimate: $2.75
P/E on far estimate: 24
Net margins: 21%

3Com ($58)
Five year est. annual growth rate: 29%
Far earnings estimate: $3.13
P/E on estimate: 18.5
Net margins: 12% last quarter, 8% year before.

Cabletron Systems ($32)
Five year est. annual growth rate: 25%
Far earnings estimate: $2.20
P/E on estimate: 14
Net margins: 15%

Cascade ($38)
Five year est. annual growth rate: 50%
Far earnings estimate: $1.64
P/E on estimate: 23
Net margins: 19%

Shiva ($18)
Five year est. annual growth rate: 37%
Far earnings estimate: $1.07
P/E on estimate: 17
Net margins: 8%

US Robotics ($64)
Five year est. annual growth rate: 32%
Far earnings estimate: $4.40
P/E on est: 15
Net margins: 8.8%

Bay Networks ($21)
Five year est. annual growth rate: 28%
Far earnings estimate: $1.01
P/E on est: 21
Net margins: 10% (year prior)

The industry is expected to grow an average 23% per year over the next five years. Only in technology do you often see such high annual growth rates, most notably in networking and in computer software. Meanwhile, 3Com is perhaps the number two company in the networking world (behind Cisco Systems), but trades at lesser prices than many peers. 3Com's gross margins and net margins are less than some peers, but were expanding last quarter, and that trend was expected to continue. David wrote yesterday of the stock's fall, "Pourquois, Trois Com?" Good question. Why the dramatic fall?

Because some analysts downgraded estimates by 3% due to one slow month? That appears to be the largest reason. But what about the threat of Intel? Compaq, IBM, and Intel all sell networking products. Some fear Intel will eliminate 3Com's healthy NIC market by offering the product on motherboards. A significant portion of 3Com's revenues come from these high margin products, but Intel enjoys strong margins on the product, too, and if they kill that market they put a bullet in their own foot.

Meanwhile, after the market today CISCO SYSTEMS (Nasdaq: CSCO) announced earnings a penny above expectations, as sales increased 73% to $1.6 billion. Still, some analysts are calling the networking sector a "sitting duck," as competition becomes more fierce, pressuring margins (which goes against what 3Com reported last quarter, of increasing margins). But looking at the leaders, none of the stocks trade at earnings multiples above their estimated five year growth rates looking less than two years out. In fact, the leaders look attractive on current estimates. Cisco is a stock in the Boring Portfolio, and Greg will discuss the earnings in his recap.

All told, the biggest ghost spooking networking is probably increased competition and decreased margins. And yes, competition looms in the headlights more prominently than before, but the companies with leading technologies will still sport impressively market-beating growth rates and very healthy margins. The networking industry is one of the most dynamic and promising when looking five to ten years out, especially for leaders such as 3Com, Cisco, and Ascend -- if they can stay in the lead, as they have been. Competition -- yes, unfortunately increasingly a part of the mix. But the industry is expanding at a rate fast enough to grow each market leader impressively. As Fools only care about 3 to 5 year time spans, at the minimum, THAT is the picture you need to look at, and there, good Fool, networking looks like a great place to invest for long-term growth.


Stock Change Bid -------------------- AOL +1 39.88 T + 1/4 39.13 ATCT - 7/8 10.13 CHV + 3/8 66.63 GM -1 1/8 57.50 IOM - 1/4 17.38 KLAC -1 3/8 40.63 LU +1 1/4 55.38 MMM + 1/2 85.13 NCR - 1/2 37.50 COMS -3 1/2 58.63
Day Month Year History FOOL -1.13% -1.36% 0.56% 168.39% S&P 500 +0.32% 0.39% 6.55% 72.18% NASDAQ: -0.17% -0.44% 6.41% 90.75% Rec'd # Security In At Now Change 5/17/95 2010 Iomega Cor 2.52 17.38 589.77% 8/5/94 680 AmOnline 7.27 39.88 448.27% 8/11/95 125 Chevron 50.28 66.63 32.50% 8/12/96 110 Minn M&M 65.68 85.13 29.61% 8/13/96 250 3Com Corp. 46.86 58.63 25.11% 10/1/96 42 LucentTech 47.62 55.38 16.29% 1/2/97 8 NCR 33.63 37.50 11.52% 8/12/96 280 Gen'l Moto 51.97 57.50 10.63% 8/12/96 130 AT&T 39.58 39.13 -1.14% 8/24/95 130 KLA Instrm 44.71 40.63 -9.14% 10/22/96 600 ATC Comm. 22.94 10.13 -55.86% Rec'd # Security In At Value Change 5/17/95 2010 Iomega Cor 5063.13 34923.75 $29860.62 8/5/94 680 AmOnline 4945.56 27115.00 $22169.44 8/13/96 250 3Com Corp. 11714.99 14656.25 $2941.26 8/12/96 110 Minn M&M 7224.44 9363.75 $2139.31 8/11/95 125 Chevron 6285.61 8328.13 $2042.52 8/12/96 280 Gen'l Moto 14552.49 16100.00 $1547.51 10/1/96 42 LucentTech 1999.88 2325.75 $325.87 1/2/97 8 NCR 269.00 300.00 $31.00 8/12/96 130 AT&T 5145.11 5086.25 -$58.86 8/24/95 130 KLA Instrm 5812.49 5281.25 -$531.24 10/22/96 600 ATC Comm. 13761.50 6075.00 -$7686.50 CASH $4639.01 TOTAL $134194.14