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.

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.

Cash cow dried up

Peter George has seen 3Com from both sides. As CEO of Crossbeam, George currently supplies 3Com with enterprise security hardware, and from 1988 to 1993 he was 3Com’s Northeast regional director.

He says the company went wrong by dabbling in too many markets ranging from commodity network adapters to enterprise switches to service provider gear. 3Com “ended up having a disjointed long-term strategy,” George says. Acquisitions such as the Kerbango Internet radio company were not in line with 3Com’s core competencies, and “they ended up losing ground,” he says.

“3Com’s money machine was network adapter cards while Cisco’s was routing and switching. 3Com went out and acquired switching technology, but this never meshed with its bridge and router business,” says Lee Doyle, an analyst at IDC.

Going all the way back to 3Com’s early days, it was the humble network adapter card that vaulted 3Com to riches. The 8-bit, 10M bit/sec EtherLink bowed in January 1987 and carried a hefty $495 price tag; by year’s end, a half-million had been snapped up. Shipments surpassed 2 million in 1991. By 2003, 3Com claimed more than 4 billion installed connections, including adapters and ports. Despite commodity pricing and relentless competition from Intel and others, NICs were 3Com’s heart and soul: they accounted for 53% of total revenue in fiscal 1995 and 44% in fiscal 1997. In 1996, 3Com’s NIC market share exceeded 42%, compared with 11% for Intel.

Today, 3Com’s Gigabit EtherLink server NIC costs about $50, and the company’s connectivity business accounts for only 16% of total revenue.

“NICs were the mother lode,” IDC’s Doyle says. “They couldn’t make them fast enough, but eventually the bottom fell out of the market. Times change.”

When Intel slashed its own NIC prices by 40% in a February 1997 bid for market share, 3Com matched the cuts, but the price war signaled the end of the NIC’s heyday. Looking for growth, 3Com acquired U.S. Robotics four months later for $7.3 billion.

There were other missteps and false starts. For a time in the late 1980s, 3Com was in the server business. Then there was 3+ Open, the network operating system developed in partnership with Microsoft. A re-branded twin to Microsoft’s own OS/2 LAN Manager, 3+ Open was 3Com’s bid to compete with Novell and its ubiquitous NetWare 386. But it was not to be. Microsoft ditched LAN MAN, and 3Com pulled the plug on 3+ Open.

“It was ahead of its time,” says Alan Kessler, a former 3Com executive. But when it was clear the business was going nowhere, Kessler personally called 3+ Open customers, explaining the decision to quit the business. “It was painful, but it was the right thing to do, and we did it at a time when we were still financially strong,” he says.

Gartner’s Fabbi sees it differently. “3Com was a hardware company. Why they wanted to be in the [operating system] business I’ll never understand,” he says.

Over the years, 3Com completed a variety of acquisitions, snapping up technologies such as bridges, token ring, remote access, ISDN, broadband, audio and telephony. But the deal with U.S. Robotics proved to be a particularly bad move, according to many analysts.

“USR was a complete disaster,” Doyle says. “They went out and bought a modem company at a time when modems were being integrated into chips.”

Fabbi agrees. “An utter disaster,” he says. Modems were already past their peak. “Cable modems were starting to hit, but 3Com never had a plan to take USR forward to newer technologies,” he says.

Kessler has a different take on the deal. He says 3Com was never interested in U.S. Robotics’ modem business.

“We didn’t want the modems; it was USR’s concentrator business that 3Com coveted, selling large [communications systems] to ISPs, carriers and telephone companies,” he says. However, even though concentrators were a huge market at the time, they diminished in importance as broadband connections gained in popularity. The timing couldn’t have been worse.

Of course, the wild card in the whole U.S. Robotics deal was Palm Computing. Palm launched its first product, the Pilot 1000, in March 1996. By December 1997, the PalmPilot had been crowned Newsweek’s “high-tech gizmo of the year.” Kessler found himself in charge of the Palm juggernaut. “Palm was moving so fast, we couldn’t get out of the way of its own success,” he says. Palm exploded into a multibillion-dollar business, eventually splitting into two divisions, one for hardware, another for the operating system.

Aside from his legendary inability to drive within posted speed limits, one bad rap that dogs former CEO Eric Benhamou is his handling of the Palm spin-off. Most people agree Palm should have been spun off because PDAs were not core to 3Com’s business, but some question Benhamou’s timing.

When Palm’s two founders went to him asking to be spun off, Benhamou declined. After they quit to form rival Handspring, Benhamou reversed his decision.

According to Claflin, that was a smart move. Benhamou rejected the advice of 3Com’s investment bankers who said an early 1998 spin-off would bring $2 billion. By waiting until March 2000, shares, priced for the IPO at $38, soared to $95, yielding a preliminary market value of about $54 billion.

“By holding on to Palm for an extra year, Eric created enormous additional shareholder value,” Kessler says. “And at the end of the day, that is precisely what a CEO is paid to do.” Today, Kessler is CEO of Z-Force, a maker of file switches.

After Palm’s IPO, 3Com spun off the U.S. Robotics’ modem business to an alliance formed by 3Com, Taiwan’s Accton Technology and Singapore’s NatSteel Electronics. The new multinational company sports an oddly familiar name: U.S. Robotics. On the same day, 3Com abandoned the enterprise business, killing off its CoreBuilder, PathBuilder and NetBuilder product lines.

In August 2000, 3Com jumped back into the acquisition fray with the $80 million purchase of Kerbango, a start-up developing an Internet radio appliance. It also was pouring serious development money into Audrey, in what was deemed the countertop Internet appliance of the future.

“Here’s an enterprise networking company, and they acquire a radio? It didn’t make any sense then, and it doesn’t now,” IDC’s Doyle says.

Nevertheless, this product duo, launched with great fanfare at the Consumer Electronics Show in 2001, was 3Com’s latest darling, the centerpiece of its “digital home” initiative.

But not for long. Three months later, both were history, shut down by Claflin in an apparent total loss. “It was very clear to me that the [Internet] bubble had burst,” Claflin says. “I made the decision to exit markets where there was little likelihood of a profitable business in a reasonable period of time.” That included the consumer market.

Metcalfe, who left the company in 1990, was a huge fan of Kerbango, extolling its virtues in a weekly column he wrote for InfoWorld and on his televised “From the Ether” Webcast show. Looking back, Metcalfe now says he did not know why 3Com bought and closed Kerbango. “Many foolish things were done by many people during that time,” he says. Whether he was referring to Benhamou’s acquisition or Claflin’s subsequent shutdown is unclear, and Metcalfe would not discuss other aspects of the company.

IDC’s Doyle was less generous. “3Com was like a yo-yo, in and out of so many businesses you never really knew what they were about. Audrey had as much to do with enterprise networking as did paying to put 3Com’s name on Candlestick Park,” he says.

In March 2003 the remaining piece of U.S. Robotics was shown the door when 3Com sold off its CommWorks unit, its one-time telco hardware business.

Back to the future

The decision to exit the enterprise market still haunts 3Com. “The move out of the enterprise market is the most damaging thing 3Com has ever done. Now it’s four years later, and it still leaves a very negative taste in everybody’s mouth,” Gartner’s Fabbi says.

But Claflin says the company had no choice at the time. 3Com had neither the right network products nor the resources to develop new products. The decision was made to get out.

Even though 3Com continues to lose money, Claflin’s radical surgery is garnering some support among investors. The company’s stock is selling at about $7 a share, well above its 52-week low of $3.91.

“If the goals were to survive and thrive, we clearly get good marks on survival,” Claflin says. “We’ll see how we do when it comes to thriving.”

“3Com still has brand cachet that will allow doors to re-open,” Crossbeam’s George says. “But when they walk through those doors they better have world-class products and a great story.”

3Com has launched a bunch of new products recently, including an enterprise-class IP-based desktop phone, an enterprise switch developed as part of the joint venture, a security switch and a Layer 3 workgroup switch.

“What will make or break 3Com is whether they can change their negative perception,” Fabbi says. They can build a great channel and support organization and have great products, but whether anyone will listen is the other side of the story.”