Questions over Bain-Huawei's acquisition of 3Com

We wrote last week about concerns in U.S. security agencies about the national security implications of the acquisition of 3Com by Bain Capital Partners LLC and Shenzhen Huawei Investment & Holding. The two companies announced, on 28 September, that they were offering $5.30 per share, a 44 percent premium over 3Com’s closing stock price on the previous day. The full terms of the $2.2 billion acquisition bid are yet to be made public. “It’s clearly a win for shareholders. When you can get a 44 percent return on your investment overnight, you take it,” Jay Zager, 3Com’s chief financial officer, said on Monday. This may well be the case, but we note that Bain and Huawei, which is an affiliate of Chinese networking vendor Huawei Technologies, offered little insight into their future plans for 3Com, including whether the company’s senior management will be retained and how ownership of the company will be structured. PCWorld’s Sumner Lemon writes that, in particular, Huawei’s role and the size of its stake in 3Com if the acquisition goes through remain uncertain. The information is not revealed in any of the documents filed with the U.S. Securities and Exchange Commission (SEC) and Zager said his discussions related to the bid have so far involved only Bain executives, despite several meetings that took place in China. These questions should be resolved soon. Full details of the acquisition bid will be disclosed in a proxy statement that Zager expects to be filed during the last week of October.

The deal will face regulatory hurdles as Huawei, which is a private company, retains close ties with the Chinese government. If reaction to Lenovo Group’s bid for IBM’s former PC division is any guide, there may well be calls to examine national-security implications for the U.S. arising from the acquisition of 3Com. Huawei and 3Com have previously worked together. In 2003 the two companies established a joint venture, called Huawei-3Com (H3C), in which 3Com held a 49 percent stake. Two years later 3Com increased its stake to 51 percent as the company became an important supplier to Huawei. 3Com bought out the remaining 49 percent of H3C from Huawei in March for $840 million, implying a valuation at that time for the joint venture of approximately $1.7 billion. The former joint venture is the largest source of revenue for 3Com and is currently the only one of its business units which is profitable, earning an operating profit of $27 million on sales of $187 million during the quarter ending 31 August. Note that 30 percent of H3C’s revenue comes from Huawei, which signed an eighteen-month non-compete agreement when it sold its stake to 3Com. Huawei’s role in the acquisition bid answers at least one question: It makes clear that it will not re-enter the market for enterprise switching network gear on its own. “The H3C-Huawei relationship, as best as we can tell, should more than likely continue far beyond the 18 months,” Zager said.

There is more to 3Com than H3C. The company’s Data Voice Business Unit, its second-largest source of revenue after H3C, reported an operating loss of $4.7 million on sales of $140 million during the most recent quarter. TippingPoint, a security company that 3Com acquired in 2005 for $430 million, reported an operating loss of $553,000 on sales of $25.5 million. Earlier this year, 3Com announced plans to spin off TippingPoint in an IPO early next year, saying its products were not a tight fit with networking gear produced by other units. That IPO is still likely to happen, but the decision to proceed will ultimately be Bain’s and Huawei’s to make if the 3Com acquisition goes through, Zager said. Lemon writes that the value of these individual units, as indicated by their previous valuations, has some investors questioning whether the bid for 3Com reflects the company’s true value, but Zager notes that 3Com’s market value is reflected in the company’s current stock price, not valuations done at an earlier time. “You can argue philosophically, how did 3Com get to a valuation on the street of $1.4 billion or $1.5 billion when the individual pieces add up to more than that, and my guess is that gets down to expectations, execution, etc.,” he said.