Hewlett-Packard Chases China With 3Com Deal

PALO ALTO, Calif. ( TheStreet -- Hewlett-Packard's ( HPQ) shocking $2.7 billion deal for 3Com ( COMS) may have been a bolt out of the blue, but could force open the door to the lucrative Chinese tech market.

3Com's stock has hardly been stratospheric in recent years as the company struggled to gain visibility for its networking technology. Despite a solid product line and a thriving business in China, 3Com's shares languished below $2.50 for much of 2008, steadily rising to the heady heights of $5.90 this year.

Clearly seeing a window of opportunity, H-P is paying $7.90 a share to get its hands on 3Com, a premium of 39% to the company's Wednesday closing price. This is small change compared to Pfizer's ( PFE) $68 billion acquisition of Wyeth ( WYE), and even Oracle's ( ORCL) protracted $7.4 billion purchase of Sun ( JAVA), but is still a significant sum. Given the premium, investors will be watching closely to see how H-P drives value out of this deal.

3Com brought in revenue of just $1.3 billion in fiscal 2009, a slight increase on the prior year. Crucially, though, more than half of the company's sales, just over $700 million, were generated in China, up from around $600 million in the prior year. Set against this backdrop, the Marlborough, Mass.-based firm is a good fit for H-P, which is frantically expanding its Chinese business, forging deals with the likes of China Mobile.

During its recent third-quarter, H-P's Chinese operation grew double digits over the prior year, leading the Asian region, and the tech bellwether is keen to tap into China's economic boom.

Tech research firm IDC estimates that the Chinese IT services market alone grew from $7.7 billion in 2007 to $9.5 billion last year, and is expected to experience a compound annual growth rate of almost 14% between 2008 and 2013.

"H-P's acquisition of 3Com would add to its expansion efforts in China and networking, providing a source of higher-margin, higher growth revenue," wrote David Bailey, an analyst at Goldman Sachs, in a note released Thursday, pointing to recent 3Com share gains in China. "3Com's strong performance in China reinforces HP's efforts to increase its presence in this key geography."

With companies like Apple ( AAPL) now attempting to tap the Chinese market, H-P is bolstering its ability to support China's service providers and enterprises, as well as Beijing's myriad infrastructure projects. The Silicon Valley heavyweight, for example, is already the technology lead for the ChinaGrid, a vast communications infrastructure for more than 290 million Chinese students.

3Com, however, has struggled to match its Chinese success elsewhere, and recently announced plans to expand its Chinese H3C subsidiary into the rest of the world. H-P could give the networking specialist new routes to market, according to Paul Mansky, an analyst at Canaccord Adams.

"H-P has channel and quality backing; 3Com brings a full portfolio with a cost model allowing H-P to aggressively attack the market while still being accretive," he wrote, in a note released late on Wednesday. "We believe this could prove potentially powerful over the next few years."

The deal, which was announced after market close Wednesday, also reflects H-P's desire to tackle its longtime partner Cisco ( CSCO) in its own backyard. The networking giant stepped on H-P's toes earlier this year when it entered the server market, signaling all-out war between the two companies.

"The acquisition clearly demonstrates H-P's seriousness about the networking market, clearly inspired by Cisco's competitive encroachments," wrote Jayson Noland, an analyst at R.W. Baird, in a note released Thursday. "This conflict has longer-term negative implications for Cisco's share."

The analyst warns, however, that it could be some time before H-P/3Com see the fruits of their labors. The two companies combined will initially have less than 10% of the enterprise switching market, he said, compared to Cisco's 66%. 3Com has nonetheless earned a reputation for aggressive pricing, and it seems likely that H-P will continue this strategy in an attempt to claw share from Cisco.

The server and storage maker plans to combine its own ProCurve networking products with 3Com's offerings, boosting its reach in corporate data centers. With many firms rethinking their IT strategies as the economy emerges from the recession, H-P is laying the foundations for an IT spending rebound, particularly around Ethernet switches and routers.

Another aspect of the deal, somewhat overlooked in all the brouhaha surrounding China and Cisco, is 3Com's security technology. The networking specialist bought Tipping Point for around $430 million in 2005, which could now boost H-P's own security story.

"H-P now owns a top-notch security business," said Cannacord Adams' Mansky. "The security portfolio already is a material competitor versus Cisco and Juniper ( JNPR)."

With cybersecurity increasingly high profile for governments and businesses, expect H-P to layer TippingPoint technology on top of its hardware, software and services offerings.

With almost 6,000 employees, however, 3Com must now be integrated into the H-P machine. Even before the recession hit, H-P CEO Mark Hurd had earned a reputation for tight cost control which could prove key in swallowing 3Com. With a market cap of $2.23 billion 3Com is also much smaller than H-P's troubled Compaq acquisition, which should make Hurd's job easier, and ease any shareholder concerns.

-- Reported by James Rogers in New York

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