3Com Turnaround Progressing Nicely

Last week 3Com Corporation (NASDAQ:COMS), which is on my list of top 10 networking stocks, reported a strong fiscal 2010 first quarter that beat estimates and increased its guidance. As per a Dell’Oro Group report, 3Com has for the fourth consecutive quarter increased its market share for enterprise Ethernet switching ports. There are strong signals that a turnaround is happening. Let’s take a closer look.

Q1 revenue was down 15.2% to $290.5 million. Net income was $7.5 million, or $0.02 per share, down from $79.8 million or $0.20 per share last year. Non-GAAP net income was $30.6 million, or $0.08 per share, beating analyst earnings estimates of $0.05 per share on revenue of $278.2 million. I have been tracking the turnaround progress for a couple of years and Q4 coverage is available here.

3Com generated $16.9 million in cash from operations and ended the quarter with $665.8 million in cash, compared with $644.2 million at the end of fiscal year 2009. Its debt balance is $200 million. It plans to make a scheduled principal payment of $48 million this week and an additional accelerated payment of $40 million, which will reduce its overall debt balance to $112 million.

By segment, TippingPoint revenue was $32.6 million, up 15.6% y-o-y and 0.7% q-o-q. Networking business revenue declined 17.2% y-o-y and 2% q-o-q to $259.2 million.

Within networking, China-based revenue was $152.0 million, consisting of China Direct Touch sales of $118.3 million (up 16.2% y-o-y and 4.2% q-o-q) and Huawei sales of $28.1 million, down 57.3% y-o-y and 36.8% q-o-q, in line with the company’s expectations. Huawei sales represented 18.5% of China-based sales and 9.7% of 3Com’s consolidated sales, but the decline was expected, since over time, it doesn’t make sense for Huawei to be buying equipment from 3Com, a competitor. 3Com’s business in China, overall, is growing steadily and has strong market share. In China, Cisco and 3Com together account for about 70% of the enterprise networking market share with 3Com controlling 32% of the Ethernet switch market and 33% of the router market — very strong market shares in a robust growth market.

Since the last quarter, 3Com has been focusing on developing its enterprise networking market outside China. It had its first data center wins outside of China with its S12500 switch. This quarter, it reported a sequential increase of 4.9% in its rest-of-world network segment with revenues of $107.2 million.

Within rest-of-world networking sales, North America revenue was $30.2 million, down 12% y-o-y but up 8% q-o-q. North America revenue increased sequentially for the second quarter in a row. During the quarter, 3Com won a core-to-edge network solution for Taser International, a developer and manufacturer of advanced electronic control devices for the law enforcement market. The company also won a deal worth slightly less than a million from Quinnipiac University in Hamden, Connecticut replacing Cisco’s switches with its core and edge switches. This might not even be a dent for Cisco, but is definitely a small victory for 3Com and a sign of things to come as more customers switch to 3Com’s lower cost alternatives.

EMEA revenue was $42.1 million, down 32% y-o-y and about the same as in Q4 with several European countries, particularly France, showing positive signs while Eastern Europe was still weak. 3Com won several marquee accounts in Q1 including a major deal with Europe’s second-largest auto manufacturer, Peugeot Citroën, for its H3C enterprise networking solutions and the Russian Savings Bank for a broad range of H3C core and stackable switches. During the quarter, one of Europe’s largest energy companies, EDF Energy, chose TippingPoint to provide land security for nuclear plants.

Latin America revenue was $17.7 million, down 24% y-o-y but up 3.3% q-o-q with improved performance in Brazil, while Mexico’s performance remained weak. Brazil’s airport administration INFRAERO selected 3Com’s core-to-edge networking solutions from H3C for more airports. In Argentina, 3Com will be providing a combined wire and wireless solution for SENASA, an agency responsible for insuring and certifying the health and quality of agriculture production, fisheries, and forestry.

Asia/Pacific revenue was down 19% y-o-y and up 17% q-o-q to $17.2 million. 3Com scored a major win with the Malaysian Ministry of Foreign Affairs, which will use the company’s H3C enterprise solution portfolio to upgrade their network backbone. Other major wins include secure voice ready network deals with UMMC, the second-largest hospital in Malaysia, and core and edge networking solutions for Australia’s Liverpool Council, which governs 38 suburbs.

For Q2, 3Com gave a strong guidance with revenue in the range of $295 million to $305 million and non-GAAP EPS between $0.06 and $0.07. China-based sales are expected to improve slightly over Q1. Sales to Huawei are expected to decline to between $15 million and $20 million in Q2 and $60 million and $80 million in the full year. Analysts expect earnings of $0.06 per share on revenue of $286.9 million for the second quarter.

The stock is currently trading around $5.26 with market cap of about $2.05 billion and annual revenue of $1.317 billion. Two analysts mirror my feelings on the stock: On September 9, Boenning & Scattergood initiated coverage on the company with Outperform, and analyst Steve Salberta said, “The company has the best shot in their recent history of taking some market share.” Jim Cramer of CNBC’s “Mad Money” was even more enthusiastic, saying, “After that incredible quarter, I think 3Com has the best opportunity to take networking market share in (its) history. This tech stock is a buy, buy, buy.”

I see 3Com’s opportunity to steal market share from Cisco on multiple fronts. In China, of course, the overall market is growing, and 3Com’s H3C has a strong presence that can continue to give Cisco a run for its money. But also elsewhere, in Latin America, India, South East Asia, and Eastern Europe — in the developing world in general where cost is an issue, 3Com has a much better structure than Cisco to cater to those markets at lower price points. And finally, in North America, as the move to drive down IT costs continues, 3Com should be able to steal market share from Cisco steadily over the next couple of years.

I have always had a fascination for turnarounds, partly because I have worked on several in my consulting career and as a result, I know how excruciatingly difficult they are to execute. However, they can be done, and when done right, they are excellent money-making opportunities because the stocks are typically undervalued for a long time even after signs are evident that the turnaround is actually happening. That is precisely where 3Com is in its history, and its stock should do very well in the upcoming months and years.