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  HP brings 3Com into the pavilion

BENJ GALLANDER and BEN STADELMANN

Friday, December 11, 2009

One stock that we toyed with adding to the Contra portfolio at various times was 3Com, the network manufacturer and former denizen of Silicon Valley that headed to the "right coast" in 2003. The move to Massachusetts was emblematic of an enterprise struggling to reinvent itself and find its footing in a crowded sector dominated by the uber-networker, Cisco Systems.

It was an ironic situation for 3Com to find itself in, given its impeccable credentials in the networking business. The company was founded in 1979 by none other than Robert Metcalfe, the electrical engineer who had considerably more to do with developing the Internet than Al Gore. While at MIT, Metcalfe built the hardware to connect the university's computers to the Arpanet, the military network that first established the protocols for email and file transfer.

Metcalfe later worked at the storied Xerox PARC, where he co-invented ethernet, the technology that became a standard for networking. The company he created became a trailblazer in developing ways for computers to communicate with other computers.

3Com's glory days were the mid-1990s, well before the Internet mania. After that came a few unsuccessful attempts at product diversification, and the spin-offs of Palm and US Robotics, accompanied by attempts to find market niches with less direct head-on competition with giants Cisco and Intel.

A key part of the strategy was to capitalize on the fast-growing Asian market, where a joint venture was formed in 2003 with China's Huawei. The combination of the play on China, a strong balance sheet and reasonable stock price made for an enticing value proposition. We also reckoned that 3Com was likely to be taken over at some point.

But the precise upside was difficult to divine. We were also concerned about a corporate pattern that, for lack of a better term, might be called Nortel Syndrome. That penchant for overpaying for acquisitions, being far too generous with management compensation and frequently sullying the bottom line with write-offs for past mistakes, has never sat well with us. Eventually, we both bought some stock for our personal accounts but gave it a pass for the Contra the Heard portfolio.

Subsequent evidence piled up that our ambivalence was warranted. Revenues grew nicely, but year after year, that evil line on the income statement called "unusual expense" had figures in the tens of millions. The relationship with Huawei got complicated, as the two partners circled to see who would gobble up the other first. In November 2006 it was 3Com that announced the purchase of Huawei's stake in the joint venture, for a steep $882 million. That transaction clouded a formerly pristine balance sheet with $336 million of debt.

With the stock price in the doldrums, private equity firm Bain Capital made an ill-fated stab at taking over 3Com for $2.2 billion. Huawei, which hadn't given up on its intention to acquire a bridgehead in the North American market, agreed to finance the deal. That involvement drew the attention of U.S. lawmakers, who fretted over the implications of China getting backdoor access to national security secrets. Many found this opposition to be contrived and an exercise in protectionism. Yeah, whatever, the price was a bit low from our point of view.

Last month, a white knight finally rode to the rescue, as Hewlett-Packard made an all-cash offer of $7.90 a share, putting a value of $2.7 billion on 3Com. That was a hefty premium over the $5.69 closing price prior to the deal's announcement. The transaction has received approval from the boards of both companies, and this time there will be no concerns over national security as HP is as American as eating pork rinds while watching the Super Bowl.

A class-action lawsuit to block the merger has been lodged by New York bankruptcy lawyer David Shaev, who alleges a breach of fiduciary duty by 3Com's board of directors. He doesn't think they pushed hard enough for a higher price. Oh, puh-lease! The stock was at $2 last March — maybe we should have sued somebody about that, too. HP's bid isn't fat by any means, but it's in the realm of reason, and it's time for this opera to wrap up and the fat lady to do her thing.

An illustrious history can only carry a company so far. A healthy enterprise must constantly prove its relevancy to the market. HP has been around for 80 years, and though it has gone through some tough times, over the long haul it has proven its mettle. As the book on 3Com closes, it is a worthy author to write the sequel.


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