Review: 3Com’s 8-K Filing for the Bain & Huawei Acquisition

The filing is meant to address the national security concerns over the acquisition of a minority stake in 3Com by a Chinese firm, Huawei. It certainly succeeds. The document is clearly and concisely written and rather pointed in dismissing the hysteria. However, reading a little deeper into it reveals a more subtle reality. While Huawei will not have managerial control of 3Com, its effective control of 3Com’s future makes those extra board seats superfluous.

The annexe to 3Com’s 8-K filing for the acquisition, filed last Thursday, the eleventh of October. Most of it is excerpted in the quotes below.

In the beginning there was H3C
3Com had been in a long, slow decline until they formed a joint venture with Huawei, China’s leading data connectivity firm.

Huawei is one of the largest customers of 3Com’s Chinese business unit, H3C. The two companies entered into a joint venture that became H3C in November 2003. At that time, 3Com owned 49 percent of the joint venture and Huawei owned 51 percent. 3Com contributed financing and Japanese and Chinese operations to the joint venture; Huawei contributed technology, products, and employees. In February 2006, 3Com acquired an additional 2 percent of the joint venture from Huawei, resulting in 3Com owning 51 percent of it and Huawei holding 49 percent. In March 2007, 3Com acquired Huawei’s remaining 49 percent stake of the joint venture. Although Huawei no longer has an ownership interest in H3C, it remains 3Com’s largest customer and reseller for H3C products (accounting for nearly one-third of H3C sales).

In effect 3Com provided a brand and some products and Huawei provided a company.

Just how important is Huawei to 3Com?
Very important. Besides providing a site, staff, products, sales, distribution, and marketing, Huawei is H3C’s best customer. 3Com’s 10-K filing from July gives some numbers:

H3C derives a material portion of its sales from Huawei. In the twelve months ended May 31, 2007, Huawei accounted for approximately 35 percent of the revenue for our H3C segment and approximately 20 percent of our consolidated revenue. Huawei has no minimum purchase obligations with respect to H3C.

So Huawei was not only instrumental in building H3C, they also provided it with a revenue stream. And how important is H3C to 3Com? Back to the 8-K:

3Com had $1.3 billion in revenue for 2007, with 50 percent of this revenue and all of its profits derived from its China-based business unit (H3C). 3Com has over 6,000 employees worldwide, with close to 75 percent in China and 10 percent in the United States.

Essentially H3C is 3Com, at least in terms of bottom-line profitability. Which means that Huawei is critical to 3Com’s existence as a going concern, both as a customer and as a business partner.

A driving force behind the transaction is that 3Com’s future success is highly dependent on its Chinese business unit, and the company’s commercial relationship with Huawei is important to 3Com’s growth and operations in China and other emerging markets. The proposed transaction will continue the relationship between Huawei and 3Com, except that Huawei will have a minority interest in 3Com rather than a large or controlling interest in H3C (as it did in the past through the joint venture (discussed below)). Huawei and 3Com will amend and extend existing commercial agreements that otherwise would expire in 2008. These new agreements are expected to result in significant growth for 3Com in markets where Huawei has a strong presence.

In terms of ownership it sounds as if Huawei is just taking a minority share in a vendor. But Huawei dominated H3C in terms of providing staff and facility resources and as a reliable customer. Most of 3Com’s staff, half of its revenue and all of its profits flow ultimately from Huawei. 3Com has become little more than a captive vendor for Huawei.

So what is the acquisition about anyways?
First the ownership particulars:

The transaction includes the following main elements: A new company controlled by Bain Capital has agreed to purchase 3Com Corporation for $2.2 billion. Bain Capital will control 83.5 percent of the voting shares. Bain Capital will appoint 8 of 11 board members. Huawei will acquire a minority interest of 16.5 percent. Huawei will appoint 3 of 11 board members. Huawei can increase its equity by up to 5 percent (but no more), based on certain performance criteria, but cannot gain additional seats on the board or gain any measure of additional operational control.

Bain is investing in the technology sector for emerging markets. 3Com is still digesting H3C and could use Bain’s expertise. The senior H3C staff from the joint venture is still in place, and their voice may have greater weight.

It’s an excellent investment for Bain. After sorting out redundancies between 3Com and H3C and winding up the unprofitable bits of 3Com, they’ll receive the lion’s share of the profits.

Huawei will solidify control of an OEM provider and gain access to a range of new products without having to go through the politically messy and somewhat expensive process of buying 3Com themselves.

What about the red menace?
As to the national security concerns:

Huawei will not have any access to sensitive U.S.-origin technology or U.S. Government sales as a result of this transaction. All of 3Com’s sales to the U.S. Government are made through resellers or integrators; 3Com does not contract with the Government directly. All of 3Com’s sales are of commercial-grade products. All are widely available, off-the-shelf products. There are no products specially designed for the U.S. Government. There are no classified contracts or facility clearances. 3Com focuses on small to medium enterprise customers.

It seems pretty straightforward to me.

TippingPoint, a 3Com subsidiary that makes intrusion prevention products, is the sticking point. Its products have been certified for and are used by the US Department of Defense, hence the security concerns. While the deal may cost some TippingPoint sales to the US federal government, it doesn’t put any existing assets at risk.

And as for the technology “falling into the wrong hands”? TippingPoint products are commercially available. Anyone with the requisite know-how could buy it and reverse engineer the chips and the software. Just ask Cisco, it’s happened to them.

Despite growing sales, TippingPoint still isn’t making any money. 3Com had planned to spin it off in an IPO, but maybe Bain will just sell it. It would be politically expedient and may help the new 3Com to focus on SMBs and emerging markets.

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