Before I dig into the meat of this post, I want to make one thing clear: I have nothing against 3Com. I don’t “hate” the company, as one commenter once charged, nor do I have any personal animosity toward those who lead it.
3Com is an interesting story, though. It’s a company that began its existence as a networking pioneer, an early innovator, and a classic American success story. Over time, it changed tack and reinvented itself repeatedly, variously targeting SMB markets, the enterprise (more than once), consumers, and even mobile devices (it owned Palm for a short time after its acquisition of U.S. Robotics in 1997).
Lately, 3Com has become primarily a Chinese vendor, though it retains an American facade. It made the transformation as a result of its now-defunct partnership with Huawei, a Chinese network-equipment vendor that has grown into a market leader worldwide as a purveyor of wireless-network gear.
What happened during the 3Com-Huawei partnership, which spawned a joint venture called H3C (Huawei-3Com), is fascinating. 3Com might be a microcosm of wider change occurring throughout the technology industry, as the tectonic plates of economic opportunity shift from west to east.
At the time the H3C joint venture was formed, I thought Huawei would get the better of the deal, learning what it could from the American company before moving on to its next conquest. That wasn’t exactly what happened, though.
While Huawei clearly benefited from the relationship, 3Com did, too. Before the H3C partnership, 3Com was adrift, seeking to reinvent itself yet again. The Huawei lifeline came just in time, and it gave 3Com a new lease on life.
After the relationship ran its course when the U.S. government discouraged Bain Capital from pursuing an acquisition of 3Com, with Huawei as a minority stakeholder, 3Com bought out Huawei’s 49-percent stake in H3C. That gave 3Com a Chinese presence, not only government and enterprise customers, but also a large engineering team that gave it a means of developing a broad portfolio of standards-based, cost-effective networking gear that could be sold not only in China but worldwide. 3Com’s “China-out” strategy was formulated, ultimately leading to where it finds itself today.
3Com’s presence in China, and particularly its engineering team, made it attractive to HP, whose pending acquisition of the company awaits approval from China’s Ministry of Commerce (MOFCOM).
Past is prologue, which is why I provided the foregoing historical overview. Now, let’s look at what’s happening how.
3Com filed its quarterly 10-Q with the U.S. Securities and Exchange Commission (SEC) yesterday. There are accounting changes, references to unresolved litigation, and mention of acquisition-related costs and a potential termination fee ($99 million) that could be incurred if the HP deal is derailed; but arguably the most compelling part of the document is a discussion of the competitive threat posed by Huawei.
The reference to Huawei comes just after 3Com’s cites risks related to sales in China. 3Com says: “We are significantly dependent on our China-based segment; if it is not successful we will likely experience a material adverse impact to our business, business prospects and operating results.”
The context here is that 3Com sales through Huawei in China are plummeting, and 3Com is being forced to compensate for the revenue erosion. It’s having a difficult time offsetting the lost revenue, as Huawei not only stops selling 3Com’s H3C gear but sells gear of its own into H3C’s installed base.
Quoting from the 10-Q:
In China, we face competition from domestic Chinese industry participants, and as a foreign-owned business may not be as successful in selling to Chinese customers, particularly those in the public sector, to the extent that such customers favor Chinese-owned competitors.
We expect that a significant portion of our sales will continue to be derived from our China-based sales region for the foreseeable future. As a result, we are subject to economic, political, legal and social developments in China and surrounding areas; we discuss risks related to the PRC in further detail below. In addition, because we already have a significant percentage of the market share in China for enterprise networking products, our opportunities to grow market share in China are more limited than in the past. Our China-based sales region has experienced growth since its inception in part due to the growth in China’s technology industry, which may not be representative of future growth or be sustainable. We cannot assure you that our China-based sales region’s historical financial results are indicative of its future operating results or future financial performance, or that its profitability will be sustained or increased.
Given the significance of our China-based sales region to our financial results, if it is not successful our business will likely be materially adversely affected.
If, as expected, Huawei Technologies, or Huawei, continues to significantly reduce its business with us, our business results will be materially adversely affected if we cannot increase other business to offset the decline.
We historically have and currently derive a material portion of our sales from Huawei, which formerly held a significant investment in our H3C subsidiary. In the three months ended February 26, 2010, which includes results from our China-based sales region’s December 31, 2009 quarter, Huawei accounted for approximately 7 percent of the revenue for our China-based sales region and approximately 4 percent of our consolidated revenue. Huawei’s percentage of our China-based sales region’s revenues has been trending downward from 46 percent during the 3 months ended November 30, 2006, to the current level. This decrease has been accelerating. We expect Huawei to continue to reduce its business with us and we believe that its purchases in absolute dollars will likely continue to decrease significantly. Huawei does not have any minimum purchase requirements under our existing OEM agreement, which expires in November 2010. We believe Huawei has begun to sell, and likely will continue to sell, internally-developed networking equipment with respect to some of the products it formerly purchased from us. We further believe Huawei also has access to other networking equipment vendors that sell products comparable to our solutions. If and to the extent any of these events occur and/or continue, it will likely have an adverse impact on our sales and business performance. In order to minimize any adverse impact on our results from any decreased sales to Huawei, we need to successfully execute on our business strategies including, without limitation,
More on Huawei follows subsequently:
As Huawei expands its operations, offerings and markets, there could be increasing instances where we compete directly with Huawei in the enterprise networking market. As a significant customer of our China-based segment, Huawei has had, and continues to have, access to H3C products for resale. This access enhances Huawei’s current ability to compete directly with us both in China and in the rest of the world. We risk competition from enterprise products that Huawei internally develops and markets or sources from our equipment manufacturer competitors. Huawei has historically sold our networking products to carrier customers (who purchase for themselves and their own enterprise customers). We believe Huawei sells internally developed products to meet carrier demand for these products and it is possible Huawei may also use these products to market and sell more directly to enterprise customers in the future. Huawei is not bound by any contractual non-competition obligations with us. We also sell carrier class products in China through our direct-touch sales force in competition with Huawei and other carrier market equipment providers.
Huawei maintains a strong presence within China and the Asia Pacific region and possesses significant competitive resources, including vast engineering talent and ownership of the assets of Harbour Networks, a China-based competitor that possesses enterprise networking products and technology. We cannot predict the extent to which Huawei will compete with us. If Huawei increases its competition with us, or if we do not compete favorably with Huawei, it is likely that our business results, particularly in the Asia Pacific region and specifically in China, will be materially and negatively affected.
Habour Networks, the Huawei-owned enterprise-networking company mentioned above, isn’t a household name in the West. In China, though, it was a formidable competitor before Huawei acquired it in 2006, at about the time Huawei was considering divestiture of its 49-percent stake in H3C. Harbour had been started by former Huawei executives and engineers, looking to replicate the best practices of their former employer. Some contend it had originally been intended as a “spin-in,” but conflict between the companies ensued, complicating matters.
In 2005, prior to the acquisition, Huawei warned Harbour that it was considering litigation related to alleged IPR infringements. The acquisition, said to be valued at approximately $212 million, negated the need for lawsuits and also gave Huawei a vehicle to compete against its soon-to-be-former joint venture with 3Com.
Siemens apparently had discussed an acquisition of Harbour before Huawei’s successful bid. At the time of the purchase, Warburg PIncus was said to be Harbour’s largest shareholder.
3Com’s sales in China are under full-frontal assault from Huawei and other indigenous Chinese vendors. Many of 3Com’s Chinese customers are government agencies and departments, and they will — following China’s “indigenous innovation” dictates — favor Chinese vendors when they make purchase decisions.
Before the HP acquisition, 3Com could claim to be more Chinese than American, hence having a fighting chance of retaining favor in key accounts targeted by Huawei. Now, though, as the property of HP, 3Com’s loss of business in China is likely to accelerate. That might seem paradoxical to Americans — after all, the assumption is that HP’s brand and corporate heft should boost 3Com’s sales prospects, right? — but different rules apply in China.
Presuming the acquisition of 3Com is approved by China’s MOFCOM — and 3Com and HP still retain hope that the deal will close before the end of April — HP will get a cost-effective engineering team, one that can help it develop competitively priced switches and routers to pressure Cisco’s margins and help it compete for price-sensitive enterprise accounts worldwide. That said, HP should not count on maintaining the substantial market share in China that 3Com built through its H3C joint venture with Huawei.
That, literally, is history.