3Com struggles amid industry boom

Following 3Com's latest Wall Street disappointment, a growing number of analysts, investors and company insiders are questioning the firm's strategy and its leadership.

The Santa Clara, Calif.-based data networking firm yesterday said revenue growth slowed in the second quarter. Additionally, the company warned that third-quarter profits would be comparable to last year's results and less than analysts' expectations.

As a result, 3Com stock dropped as much as 17 percent early today while analysts cut earnings estimates for the third quarter and the fiscal year. Shares recovered slightly to end the day down more than 8 percent.

Wall Street now expects the company to earn 26 cents a share, down from a previous consensus of 32 cents, according to First Call. For the year, 3Com is now expected to earn $1.26 a share, compared with previous estimates of $1.35.

3Com chief executive Eric Benhamou has led the networking firm through a number of financial and strategic crises over the past two years, yet has faced industry criticism throughout. Yesterday's news will no doubt put even more heat on Benhamou and his beleaguered company.

After the latest announcement, critics say it is clear that the success of its Palm Computing subsidiary has obscured greater underlying problems at the networking firm. Once Palm is spun off as a separate company next year, 3Com will be left with a stagnating networking business that has recently shown few signs of significant growth. As an example, the company's sales of networking systems products--a vital cog in the company's strategy--were down 12 percent sequentially for the second quarter.

"Their Palm business has brought the overall stock up, but it's no secret that 3Com has some underlying problems with their core networking business," Cahners In-Stat Group analyst Michael Wolf said.

"The majority of where they've held market share has been commodity segments, and that continues to be the case. They are continuing to experience problems transitioning to more profitable areas," he added.

For 3Com investors and analysts, the current turmoil is the sum total of two years of repeated disappointments. The company has been plagued with a lackluster stock price, stagnant revenue growth and miscalculated strategic moves that have yet to improve the company's fortunes.

By contrast, heavyweight competitors such as Cisco Systems and Nortel Networks have each seen their share price soar as telecommunications carriers, Internet service providers (ISPs), and corporations line up to buy their equipment.

Yet executives remain optimistic in the face of increasing competition and Wall Street criticism. Bruce Claflin, hired as president and operating chief last year to handle the daily operations of the networking firm, said 3Com is now on the right track.

"The strategy of the company is becoming more focused and clear," Claflin said.

But in a year noted for the tremendous gain in technology issues, 3Com stock is ending up almost where it began.

Shares of the networking company fell in February and languished for most of the year. The stock has perked up in recent months, however, largely as a result of its plans to spin off its popular Palm unit, Hambrecht & Quist equities analyst Erik Suppiger said.

For some industry insiders and analysts, the responsibility for the company's malaise lies with Benhamou, who has led the company since 1990.

"The company's not performing," one former 3Com executive said. "In this incredible growth market, [Benhamou] had a vision…that went wrong."

Sanford C. Bernstein analyst Paul Sagawa said Benhamou takes too long to ponder strategic decisions when quick, decisive action is needed.

"Eric is very intellectual and treats things that way," Sagawa said. "But his personal style is probably part of the reason they've puzzled over making sense of their existing businesses, as opposed to stating a focused vision and striding toward it. The company is clearly crying for a much more articulated direction and focus. Eric's never been 'Mr. Vision.' He needs to step up to the plate."

3Com declined CNET News.com's request for an interview with Benhamou unless all sources were named, according to Brad Leone, a company spokesman. CNET News.com did not agree to the terms, given assurances made to sources.

3Com directors this year made sure that Benhamou's compensation was more closely tied with the company's stock performance. The CEO received 273,425 option grants this year--more than twice the number he received last year. Benhamou's base salary grew 1 percent to $750,000 and no cash bonus was given, according to the company's filings with regulators.

"Benhamou's compensation package was designed to be strongly aligned with the interests of stockholders by making his short-term cash incentives and long-term equity incentives directly tied to achieving specific targets," the proxy stated.

In recent years, 3Com's stock has lagged behind the Standard & Poor's 500 Index and the S&P Technology Sector Index.

For example, a $100 investment in 3Com back on May 31, 1994, would have been worth $232 five years later. That same $100 would be worth $316 had it been invested in the S&P 500, or $561 had it been invested in the S&P Technology Sector. If a similar investment was made in Cisco on July 31, 1994, it would be worth $2,662 five years later.

Start-ups in the networking space have eclipsed 3Com in market share. Foundry Networks, a company that went public this year, makes similar networking technology to 3Com. Yet Foundry has a market capitalization of $18.1 billion, compared with 3Com's $16.5 billion.

"The board is concerned with the stock price and thinks the company is undervalued," said a source familiar with the discussions of 3Com's directors.

Faced with an undervalued stock, over the past few years 3Com has been the subject of buyout rumors. Sweden's Ericsson and German networking firm Siemens are among the companies rumored to be interested.

"Eric's not opposed to a buyout, but he doesn't see it as a salvation. If someone approaches the company with an unsolicited offer at a premium [to where the stock is currently trading], the directors will take a look at it," said a source familiar with the company's board.

Yet despite many concerns, directors are confident in Benhamou's leadership, a source said.

"[The directors] have a lot of confidence in Eric…The company's problem isn't Eric. No one thought the modem market would crater, and the US Robotics acquisition had a lot more problems than anyone thought there would be."

The source added that the appointment of Claflin shouldn't be construed as an effort to push Benhamou aside.

"Bruce is a good counterpart to Eric. Bruce is driving the sales and operations of the business and Eric provides the vision and strategy. It's a good fit that blends very well," said the source.