The 3Com saga

3Com turns 25 this June, but the Ethernet pioneer probably won't spend much time celebrating - it's too busy fighting to stay relevant. The last several years have been difficult for the longtime industry mainstay; it's been a dizzying, roller-coaster ride of spin-offs, write-offs, layoffs and strategic about-faces.

Meanwhile, the company's financial position has steadily deteriorated. In 1999, 3Com was a profitable $5.8 billion company; last year it was a money-losing $932 million shadow of its former self. And a return to profitability seems a long way off - 3Com has lost $330 million in the first three quarters of fiscal 2004.

Founded in 1979 by Ethernet co-inventor Bob Metcalfe, 3Com still enjoys enormous brand recognition that dates to its early leadership position in network adapter cards. But the company also has a history of missteps and failed opportunities, including expensive forays into operating system software, analog modems and Internet radio.

In 2000, 3Com made what some analysts say was its most damaging move of all. It walked away from its enterprise LAN equipment business, ceding the market to Cisco, angering dealers, driving away customers and eroding revenue.

Today, 3Com President and CEO Bruce Claflin wants that enterprise business back - and more. Positioning itself as an affordable, standards-based alternative to Cisco, 3Com is betting its future on enterprise switching, VoIP, wireless and security products.

To drive down costs, 3Com has slashed its payroll and shuttered factories. Rather than manufacture products in-house, 3Com has adopted a multi-part strategy that includes outsourcing to companies such as Flextronics and Jabil, reselling products from other vendors (such as security switches from Crossbeam Systems) and embarking on a bold joint venture with a Chinese manufacturer.

3Com invested $160 million last year to establish an engineering and manufacturing joint venture with Huawei Technologies. In the first arrangement of its kind between a U.S. network company and a Chinese partner, the joint venture will develop and manufacture enterprise switches and routers that will be sold in China and Japan under the Huawei-3Com banner and in the rest of the world as 3Com gear.

"We've spent the last year and a half building out a complete portfolio of enterprise products," Claflin says. The CEO knows plenty about portfolio building: In the early 1990s he was the No. 2 man at Digital Equipment.

The task at hand is to increase revenue, which won't be easy because 3Com's connectivity business is spiraling downward. The network interface card (NIC), PC card and ASIC parts of the business, once the company's cash cow, brought in $51 million in the third quarter of 2003, but only $23 million in the third quarter of 2004. Claflin predicts a 40% decline in the current quarter.

The challenge then is to significantly boost revenue from enterprise products. The enterprise business stood at $149 million in the third quarter of 2004, down from $166 million a year earlier, and the company is predicting only a 5% to 7% increase in the current quarter. The joint venture is still in its early stages and is not contributing significantly to 3Com's bottom line.

Could have been a contender

Instead of being merely a Cisco alternative, 3Com could have been a contender. In the early 1990s, 3Com was actually bigger than Cisco, with sales of $723 million in 1993, compared with $649 million for Cisco. But price erosion began ravaging the adapter card business, 3Com was late to the Ethernet switch party, and the merger with U.S. Robotics was a bust. Cisco saw revenue skyrocket, thanks largely to the Internet boom of the late 1990s and demand for its high-end switches and routers, .

By 1996, Cisco was almost twice the size of 3Com - $4.1 billion vs. $2.3 billion. By 2001, Cisco was more than nine times bigger - $22.3 billion vs. $2.4 billion. And today, Cisco is roughly 20 times bigger - $18.9 billion vs. $932 million.

Despite its changing fortunes, 3Com is not in imminent danger of disappearing, thanks to its $1.4 billion cash horde. But the company continues to hemorrhage money: it hasn't reported a profit since the fiscal year ending June 2, 2000. And the consensus earnings forecast from 12 analysts, published recently by Nasdaq, projects yearly losses through fiscal 2005.

For the quarter ending Feb. 27, 3Com reported sales of $172 million, down 21% from $216.5 million last year. Losses totaled $86 million, up from $79 million the year before. In the second quarter, sequential revenue was up 12%, which seemed to offer some hope that the company had bottomed out, but third-quarter revenue was down 4% compared with the second quarter.

Despite the barrage of bad financial news, Claflin remains positive. He says the wireless, security and IP telephony markets show signs of life, and 3Com has products in all of those areas. He maintains that 3Com's survival has never been in doubt.

"We did one thing really well early on," Claflin says. "We made absolutely sure we protected our balance sheet. While the company had lots of difficulty and had to do all kinds of downsizing and changes, there never was a question as to whether or not our existence was in jeopardy."

Claflin says his strategy for growing the company is to be a lower-cost alternative to Cisco and whether the products are designed and built by 3Com is less important. The joint venture with Huawei lets 3Com ride shotgun over product development while ridding its own payroll of expensive engineering talent and manufacturing plants.

"A year ago 3Com had about 300 engineers on its payroll developing product. Today, we have closer to 900 engineers working on our behalf. Yet the cost of this is all off our books," Claflin says.

According to Gartner analyst Mark Fabbi, Claflin's math is on the money. "A Chinese engineer costs one-sixth of an American engineer. Not only is 3Com getting a good deal, Huawei is garnering an increasingly good reputation in Asia," he says.