From M&A Impact, a sister publication.
In February, Wall Street was stunned by news of the largest merger in the history of data networking. The deal, a $6.6bn share-swap transaction between 3Com Corp and US Robotics Corp, will create a networking giant with $5bn in revenues and a product portfolio spanning adapter cards, hubs, low-end switches, modems, and high-end remote access hubs.
By Krishna Roy
Wall Street’s amazement at the size of the deal and the players involved in it has quickly turned sour. 3Com’s stock, which had been trading at $39 the day the merger was announced (CI No 3,110) fell to $32.88 by the following Monday, while US Robotics stock slid 9.2% from $61 to $55.38 over the same period. The deal, described as a merger of equals, will actually give 3Com a majority representation on the new board so it will have the controlling reins over the new coalition’s future strategy and product plans. US Robotics will no longer operate as a separate company but will be subsumed into the newly restructured 3Com which is now split into three separate business units. The enterprise business unit will be built around the company’s lines of hubs, switches, routers and network management software, while the carrier business unit will focus upon system sales to network service providers and telecommunications companies. The client access business unit will sell modem and network interface cards through its reseller channel. 3Com’s strategy is clear: it is trying to fashion itself into an end-to-end networking company, providing users with a product set that extends beyond its core LAN niche. It is therefore unlikely to drop many USR products as USR covers a different area of the networking market to 3Com, mainly manufacturing remote access products such as modems and hubs.
However, there are two overlaps which will result in certain products being phased out. 3Com has two remote access hubs, the Access Builder 4000 Remote Access Server and the Access Builder 8000 Integrated Remote Access Server which are used mainly by Internet Service Providers to provide Internet access to their customers. The hardware has met with limited success, particularly in Europe, where vendors have tended to look to market leader, Ascend Communications Inc for products in this arena. In the long term, 3Com will phase out Access Builder in favour of USR’s Total Control product family, which is number two in the market behind Ascend. US Robotics acquired Ethernet specialist, AmberWare, early last year to provide it with an Ethernet switch offering which it now sells under the Total Switch brand. Given 3Com’s dominance in the Ethernet switch market place, it is likely to discontinue the Total Switch product. Users should therefore seek clarification on how long 3Com plans to continue supporting both products and what alternatives are available to them. Another potential product casualty is USR’s personal digital assistant, Pilot. Although the product has been successful and is estimated to have a 51% market share according to one analyst group, 3Com is unlikely to see the PDA market as a strategic area of business in the long term. At the time this deal was announced on February 26th, the 1.75 shares in 3Com offered for each share in US Robotics represented a premium in value of around 12% over USR’s closing price on the day. But USR’s shares were sitting close to their 52-week low at the time, prompting disgruntled stockholders to feel extremely hard done by. Many were no doubt expecting USR’s shares to take off at any time, fuelled by the speculation from the analyst community on the hidden potential in networking stocks. Many USR shareholders believe the company was undervalued arguing that Casey Cowell, USR’s chief executive, gave the company away – 3Com paid roughly three times USR’s fiscal 1996 revenues. Trying to prove that USR’s shares would have risen while 3Com’s fell, in some hypothetical future where the merger didn’t happen is nothing short of pure speculation. As it turns out, networking stocks rallied in May, with the now inextricably linked 3Com and USR doubling their values in a single month. So do USR’s stockholders really have anything to complain about? A quoted company’s market value theoretically encompasses all information publicly available on the organization at the time, including earnings projections. On this basis, USR shareholders should be happy with the 12% premium offered. But the reality is that companies are often substantially over or undervalued because market sentiment, rumour, and the actions of large institutional investors affect the price. USR has shown a compound annual growth rate in earnings per share of 64% over the past four years, with turnover growing in excess of 100% per annum over the same period. This has slowed to just 31% and 7% respectively for the quarter ended March 31st this year and people were beginning to suspect that USR’s limited product line was looking vulnerable. 3Com’s growth is also showing a dramatic slow down from the 50% historic rate. Revenues actually fell in the quarter to February 1997 and the company warned in its own quarterly report that historic growth rates could not continue. But, 3Com said that in the worst case the acquisition will be neutral to its earnings for 1998. It will take a charge of between $325m and $375m in the quarter but says that it will achieve earnings estimates of $2.08 a share for fiscal 1997 and $2.70 a share in 1998.
So the deal looks fair from USR’s perspective if the company is indeed running out of steam, and 3Com gets to expand quickly to a size where it feels it can take on Cisco Systems Inc. There is also scope for considerable cost savings which will boost earnings. One saving resulting from the merger is that USR had been planning to set up a new manufacturing facility in Ireland. 3Com already has a substantial manufacturing base outside Dublin which it is currently expanding. Both companies are talking optimistically about using each others existing sales channels to expand distribution. USR and 3Com are masters of two-tier distribution, and cross-pollinating the existing channels is a logical move as, in many cases, both companies have the same distribution partners. So, disgruntled shareholders aside, its hard to spot any losers in this deal. Although 3Com’s USR acquisition has elevated its credentials as a commodity network equipment provider, the deal has done little to improve its position within enterprise accounts. The main reason for its lack of success at this level is that it is still missing a vital networking component – a core wide area network switch. Rectifying this problem could take some time. Developing the product in-house would take too long. The networking industry has a product churn rate of 3-6 months and the development of a core WAN switch could take considerably longer. Gaining such a product through acquisition looks equally doubtful as there are few acquisition targets in the WAN market. On the contrary, many WAN suppliers, such as Newbridge Networks Inc and Northern Telecom Ltd, are embarking on acquisition sprees of their own. Furthermore, having just begun to digest its USR acquisition – finalised last month (CI No 3,180), it will be some time before the company will have the appetite to swallow another vendor.