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Adding Negatives Somehow Comes Up Positive for Broadcom

Tell me again why the communications chip maker is so expensive.

Be sure to connect the dots.

Siebel Systems

predicts

(SEBL)

, weeks ago, that Europe will be weak. Weeks later,

Sun Microsystems

(SUNW) - Get Report

and

Juniper Networks

(JNPR) - Get Report

suffer from weakness in Europe.

Cisco Systems

(CSCO) - Get Report

sees its business dry up and promises to play tougher; Juniper, which previously had been eating Cisco's lunch in the market for high-end routers, preannounces that its revenue will be light by $100 million, or a third of what it had expected, for the second quarter.

Next dot:

3Com

(COMS)

, the pioneering networking equipment maker that can't seem to do anything right anymore, says it's getting out of the consumer cable and digital-subscriber-line modem business. Could there possibly be a connection to the performance of 3Com supplier

Broadcom

(COMS)

, the chipmaker that dominates the field for the components that go into cable modems?

If so, investors aren't too worried. Shares of Broadcom, even after Friday's 9% drop to $36.79, still are above their levels at the close of market Wednesday, when Broadcom preannounced that its second-quarter revenue would be about 20% lower than the company previously expected. For all the doubts about Broadcom's accounting of revenue booked from customers that received warrants in companies subsequently acquired by Broadcom, the now unprofitable chipmaker remains richly valued. Despite slipping revenue and shrinking gross margins, Broadcom is worth nearly $10 billion on projected annual revenue of well under $1 billion. And yet, shares of Broadcom soared 13% Thursday because the company expressed confidence in a second-half recovery and because it reported that order cancellations by its customers had slowed.

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Perhaps overlooked, however, is one important customer Broadcom increasingly won't need to worry will cancel orders: 3Com. The company that invented Ethernet connections but then lost out in the enterprise equipment business to Cisco, accounted for 15.5% of Broadcom's first-quarter revenue, according to Broadcom's 10-Q filing with the

Securities and Exchange Commission

. (Another besieged company,

Motorola

(MOT)

, accounted for 18.6% of revenue.) Says Broadcom in its filing: "We expect that our key customers will continue to account for a substantial portion of our revenues for 2001 and in the future. Accordingly, our future operating results will continue to depend on the success of our largest customers and on our ability to sell existing and new products to these customers in significant quantities."

Broadcom downplays the significance of 3Com's discontinuation of its consumer cable modem business. "This represented a very small part of Broadcom's total revenue," a spokesman says. "This was not unexpected and therefore was already built into our plans. The 3Com business will be absorbed by other Broadcom customers."

And yet, one wonders if this will be the end of bad news from Broadcom's second biggest customer. A 3Com spokesman notes that 3Com now has discontinued consumer cable and DSL modem lines, scrapped plans to introduce an Internet radio aimed at consumers, withdrawn the consumer-oriented Audrey Internet appliance and sold its consumer analog modem business. "I think we're about done," he says, noting that the company also has said it's evaluating all its product lines.

(Clue to 3Com's ability to predict the past, let alone the future: It said on June 8 its revenue for the quarter ended June 1 would be between $450 million and $475 million. That's a $25 million margin of error for a quarter that ended a week earlier.)

Even Wall Street is skeptical about Broadcom's prospects at this point. "The decline in cancellations and the slightly better order activity is encouraging but still very tentative," writes Clark Westmont, communications chip analyst for

Salomon Smith Barney

, in a note to clients. "(But) compression in gross margins remains a concern and further declines are expected. This may compromise the company's profitability even after sales recover." Specifically, Westmont expects gross margins of 45% in the June quarter, compared with 53.7% in the March quarter, and he expects those margins to "decline each quarter for the remainder of the year." (Only a year ago, Broadcom was making gross margins of 58%, for which it was lauded in

this space.) Westmont has a $27 price target on Broadcom, which he rates a neutral.

Chimes in Kalpesh Kapadia, an analyst with

C.E. Unterberg Towbin

: "Considering the run-up in the stock following the conference call, we believe investors are over-enthused with the notion that the worst is over."

If the worst is to be over at Broadcom, the worst needs to be over at 3Com, at least until 3Com ceases to be a major Broadcom customer. In a statement , ex-

Digital Equipment

executive Bruce Claflin, president and CEO of 3Com, said the company's "strategy is to focus on businesses and service providers, delivering advanced networking solutions that leverage leading edge technologies. These are areas that play to 3Com's strengths." (3Com, whose shares dropped 20 cents, or 4%, to $5.46 Friday, didn't hold a conference call to announce its news. It reports financial results June 26.)

Of course, if 3Com's alleged strengths deteriorate any further, the dots will be easy to connect to a still weakening Broadcom.

In keeping with TSC's editorial policy, Adam Lashinsky doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. Lashinsky writes a column for Fortune called the Wired Investor, frequently guest hosts the TechTV cable television news show Silicon Spin, and is a regular commentator on public radio's Marketplace program. He welcomes your feedback and invites you to send it to

Adam Lashinsky.