BY NEAL WEINBERG Network World, 4/24/00 Evaluating the financial health of key vendors is a lot like troubleshooting your network. But instead of wading through a blizzard of reports generated by network management tools, you need to decipher the hidden meaning in reports written by financial sorts. While vendors can say pretty much whatever they want in marketing brochures and sales pitches, they face severe penalties if they play fast and loose with the facts in Securities and Exchange Commission filings. In other words, the information contained in annual reports, quarterly earnings statements and other public documents filed with the SEC is as close to the truth as you're going to get.Red Flags Look for these vendor warning signs. Start me up Judging a newly public company's health is tricky. Thanks to the Internet, these documents are at your fingertips, readily available from most vendors and at www.sec.gov. At the latter site, you'll find EDGAR, a searchable database of documents filed by public companies with the SEC. Quarterly earnings and annual reports are filed on 10-K forms, so those are your first stop. Don't be put off. The consolidated balance sheet on a 10-K can contain page after page of mind-numbing figures, but you just need to zero in on two lines - revenue and net income. Revenue is money coming in from any and all sources. This includes the ongoing revenue stream from the sale of goods and services and one-time gains from the sale of buildings, equipment, product lines, business units, patents or technologies. Net income, also referred to as profits or earnings, is what's left over from revenue after subtracting the cost of doing business or the cost of sales. Costs include research and development, production, and the cost of sales, general business expenses and administrative costs. Of course, a vendor also can chalk up one-time costs if it buys the assets of another company - an increasingly common trend in networking. What you're hoping to see in a healthy company is a strong, sustained increase in revenue and earnings, when all the one-time charges are subtracted. With a start-up, you're looking for signs that revenue is increasing and that the company has enough money to stay afloat until it begins turning a profit. If an established vendor reports an increase in profits but declining or stagnating revenue, that could signal trouble. It's possible the company is covering up for slow revenue by cutting enough on the cost side to continue showing a healthy profit. But if revenue isn't keeping pace with the rest of the industry, that could mean products are late to market or those wares aren't getting a favorable reception among customers, for example. If revenue remains sluggish over several quarters, the company may be forced into deeper cuts. Those cuts could affect the service you receive or hamper development on product lines you favor. Let's take 3Com as our first patient. In the company's quarterly report released Dec. 21, 1999, sales were down 4% from the same period the prior year. Income, subtracting all one-time events, was $131 million, a decrease from the $133 million reported one year earlier. All in all, revenue and earnings were weak. Of course, it's not a good idea to draw conclusions based on single quarter. Let's look at the past six months, or the first and second quarters of 3Com's fiscal year 2000, which began May 29, 1999. 3Com sales were down from $2.9 billion in 1999 to $2.8 billion in 2000. How about the past three years? Sales went from $5.6 billion in 1997 to $5.4 billion in 1998, edging up to $5.8 billion in 1999. That's nothing to write home about, especially since 3Com's Palm division, since spun out, had been going gangbusters and the national economy was on a roll, in large part buoyed by the fast-growing networking segment. By contrast, Cisco grew from $6.4 billion in 1997 to $8.5 billion in 1998, and to $12.1 billion in 1999. So if you were the doctor examining 3Com, you'd be ordering some extra diagnostic tests.The Wall Street angleChecking revenue and profits is a good first step, but a thorough exam requires drilling down into other metrics. Your next stop: Wall Street, to look at stock performance. Stock price is a key barometer of a company's health because the stock market sets a value on a company based on a six- to nine-month performance projection. So if your vendor's stock is on a sustained downward slide, find out why. With the explosion of Internet-based stock trading companies, as well as the proliferation of online business news, it's relatively easy to obtain good financial information. One thing to keep in mind is that analysts have their biases, so find one you have confidence in. If you need to buy a few shares of stock in order to get access to a particular analyst's reports, consider it money well spent - as long as you're not violating company policy. Also understand that your interests and the goals of the financial community are not the same. You want your vendor to stay the course, to continue developing and supporting product lines. Wall Street doesn't care about that. If severe cost cutting, which could mean discontinuing a product line, would boost profits, Wall Street would be all for it. And if selling the company altogether would result in a big stock gain, then Wall Street would love that, too. Which brings us back to stock price. Simple math tells you that if a stock drops by half, then purchase price just dropped by the same margin. So a decline in a company's stock price is directly proportional to its vulnerability to a takeover. Cabletron's stock hit a high of $46.50 a share in the first quarter of 1998, but dropped to $12.63 by the end of that year. That's a warning sign. After you've checked out revenue and profits and have analyzed stock performance, it's time to dive into the guts of the annual report to look for trouble signs. What would these look like? Well, that's the hard part. Essentially, you're like a specialist with a new patient, looking for buried symptoms of disease. It's impossible to list all the categories here. But trouble signs can include too much inventory, litigation, declining profit margins, credit woes, cash flow shortages, unraveling relationships with resellers or customers or skyrocketing materials costs. Here's a look inside Cabletron's 1998 annual report: First, revenue went down 2% and profits dropped from $222 million to $130 million. Were Cabletron's 1998 woes a one-time bump, or did they indicate a more serious problem? Proceeding through the 10-K, you find that sales of the company's core product - hubs - plummeted 57% and that "the company expects the decrease in sales of its shared media products to continue." Under the heading "Business environment and risk factors," Cabletron frankly assesses its predicament. It states that competitors, including new enterprise data players like Nortel Networks and Lucent, are bringing products to market quickly by buying smaller data network companies that have hot technologies. Prices for these companies are extremely high, and Cabletron's deep-pocketed competitors are better able to afford them. Bottom line: "In the past, Cabletron has relied on a combination of internal product development and partnerships to broaden its product line. Acquisitions in other data networking companies by Cabletron's competitors may limit Cabletron's access to commercially significant technologies and thus its ability to offer products that meet its customers' needs." By the time Cabletron issued its 1999 annual report, its stock price during the fourth quarter had dropped to a low of $7.69 per share. The report noted that the company's product mix was shifting from high-margin hubs to low-margin switches. Not only that, Cabletron was moving from direct sales to a reseller model - in other words, it was adding middlemen and that was cutting into profits even more. Plus, Cabletron identified four new, well-heeled competitors on the horizon: Alcatel, Ericsson, Nokia and Siemens. If you had been monitoring Cabletron's financial health, it would have come as no surprise that the company was in need of radical surgery - which is just what happened with its February dissection into four independent companies.A successful surgery, but the patient diedAlso keep in mind is that a company may choose a road to financial health that involves selling, discontinuing or de-emphasizing the product line you care about most. On Feb. 17, Novell announced its results for first-quarter 2000. It may have been a coincidence, but on that same day, Bill Gates formally introduced Windows 2000 with Active Directory, a direct threat to Novell Directory Services (NDS). Here's the way a stock analyst might look at the numbers. Novell reported an 11% increase in revenue, which is OK, but certainly not spectacular. Revenue from the NetWare line increased a paltry 6%, which isn't encouraging considering that the long delay of Windows 2000 was Novell's window of opportunity to grab market share. And listen to what Novell CEO Eric Schmidt has to say about long-term plans: He's promising to transform Novell into an e-commerce company, with the goal of growing "revenue from 'Net services software products that rely on NDS eDirectory to support e-business." And what has Novell targeted as hot growth? Public-key security, cache management and personal identity control. Notice anything missing? NetWare, perhaps? This isn't to say that Novell will do anything to alienate its NetWare customers, but if you're among that crowd, it's something to watch. On to 3Com. For the second-quarter 2000, the company reported that sales of enterprise network products - switches, hubs, routers, network management software and remote access concentrators - dropped 12%. In response, CEO Eric Benhamou identified five emerging high-growth markets to focus on: voice over IP; LAN telephony; wireless, broadband cable; and digital subscriber line; and home networking. There's not an enterprise network product among the bunch. As if that wasn't a bright enough red flag, in the 10-K's fine print, 3Com said it was late shipping the CoreBuilder 9000 eight-slot chassis, Gigabit Layer 3 modules and CoreBuilder 3.0 software. Anyone doing the reading had to wonder: Was 3Com committed to these products, or not? The answer, as we know now, is not. On March 20, 3Com announced it was discontinuing its CoreBuilder Layer 2/3 Gigabit Ethernet and ATM LAN switches, and its PathBuilder and NetBuilder WAN switches and routers. Some customers felt blindsided by the news, but it was all there in the financial reports.
Related links
Enterprise infrastructure market - 1999
Carriers market - 1999
Revenue growth
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