Performance Concerns Surround Post-Palm 3Com

Several observers question the parent's ability to thrive without its favorite son.
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SAN FRANCISCO -- By sending its

Palm

division off to the market in what is expected to be

a torrid IPO Thursday,

3Com

(COMS)

is saying goodbye to its favorite child.

Now the question is: What's the fate of the parent?

With the IPO, the Santa Clara, Calif.-based company is releasing the unit that has sold 5.5 million Palm handheld computers and currently generates 18% of 3Com revenue. In doing so, 3Com will lose the huge boost that the Palm has given to the company's stock. Shares of 3Com are up 186% in the last four months, reaching highs untouched since December 1996, largely in anticipation of the Palm IPO. The stock finished at 80 11/16 Friday.

But Palm's departure leaves new questions about 3Com's prospects. While Palm is growing 76% year over year, 3Com's overall sales are roughly flat. Its modems and PC adapter cards have become a commodity, and in the business of network switches, 3Com finds itself losing out to one of the most ambitious companies in Silicon Valley --

Cisco

(CSCO) - Get Report

.

To try to jazz up its core business, 3Com is devising systems for new broadband, Internet telephone and wireless-network markets. And it is advising corporations on how to create so-called

e-Networks

for business applications.

But the success of these efforts isn't yet clear, and it will be tough to predict company performance during this transition. As a result, the same experts who promote Palm remain cool on 3Com. They worry that the stock will return to its pre-Palm performance of 1997 and 1998, a period in which shares climbed as high as 60 only to tumble back toward 20.

The Empty Nest

On Thursday, 3Com is scheduled to sell its first chunk of Palm holdings, issuing roughly 23 million shares at an estimated range of 14 to 16. 3Com expects to hand its entire interest in Palm to 3Com shareholders in about six months. At that point, 3Com stock will cease to be a proxy for Palm.

3Com believes its post-Palm strategy will please investors. "You will see a more focused 3Com coming out of the Palm spinoff," says a spokesman, as the company tackles its new markets. Analysts say that shedding Palm will enable 3Com to work more closely on potentially rewarding projects with

Microsoft

(MSFT) - Get Report

because the software giant's own brand of operating systems competes with Palm. Currently, Microsoft writes 3Com code into its Windows 2000 software. But analysts are concerned that once Palm is independent, the 20-year-old parent will find itself with limited prospects for recovering old growth prospects.

"Once 3Com distributes shares, there's certainly a pretty substantial likelihood we'll see the value of 3Com come down quite a ways because it will no longer reflect the value of the Palm division," says one equity analyst who asked not to be named, even though his firm has not acted as investment banker for the company.

3Com stock "is suitable for investors with a tolerance for the price volatility associated with technology stocks," writes George Kelly, who covers the network-equipment sector for

Morgan Stanley Dean Witter

, in a Feb. 15 report. Kelly, whose firm is underwriting Palm's IPO, rates 3Com hold. He couldn't be reached for comment.

The Cisco Kid

3Com is in a tough spot. With its products maturing and competitors cutting prices, the company has managed to perform to analysts' expectations by streamlining operations and inventory. It reported net income of $130.9 million, or 37 cents a share, for the second fiscal quarter ended in November, excluding investment gains and a realignment charge. That compares to pro forma net income of $133.4 million, or 36 cents a share, a year earlier.

3Com continues to lag industry juggernaut Cisco in the business of building network switches for the Internet. It also draws two-fifths of its revenue from less-profitable modem and PC adapter cards. Overall sales have been roughly flat for six quarters, amounting to about $1.5 billion in the November quarter. In that time, Cisco has increased its quarterly sales 67% to $4.4 billion, selling similar products to similar corporate and telecommunications clients.

3Com "is retrenching in its core business, and during this transition, we expect investors will focus on 3Com's restructuring efforts," Kelly writes. Kelly expects 3Com to fall short of its goal of 15% to 18% operating margins for some time.

3Com's assets still might fetch investor interest in a sector driven by superb growth. The research firm

RHK

predicts that Internet traffic in North America will increase roughly 30-fold in the next three years, and customers are demanding new services that combine voice and data messages.

But money manager Erik Gustafson says he still isn't buying. "I don't like companies that have to compete with Cisco," he says. Gustafson's large

(SRFSX)

Stein Roe Growth Stock fund is a major Cisco shareholder. "Cisco has mind share, Cisco has shelf space, Cisco has the best management team in technology period," Gustafson says. He continues, "You add all that together, and I'm not overly keen on 3Com's ability to compete."

Reporter

Beth Kwon contributed to this story.