Bain buys 3Com for $2.2 billion

Private equity firm Bain Capital Partners and ChinaÆs Huawei Technologies will buy network equipment maker 3Com for $2.2 billion. The price translates to $5.30 per 3Com share, a 44% premium to the closing price on the Nasdaq on September 27.

The exact stake which will be held by Huawei, China's largest telecommunications equipment provider, was not disclosed but sources close to the deal say that the firm will own between 10% and 20%.

Citi and UBS are advising Bain and Huawei on the deal.

As a result of the transaction, Huawei gains enhanced distribution traction in new non-Asian markets. ôHuawei probably has the most to gain from this transaction and now has an entry into the US market," says RBC Capital Markets analyst, Mark Sue, in a research update titled ôBain saves me the painö which was released after the deal was announced.

This deal follows less than a year after 3Com acquired full ownership of its China-based joint venture with Huawei, then called Huawei 3Com and since renamed H3C.

Bain and other private equity firms were in the fray for HuaweiÆs 49% stake in H3C, which 3Com finally won. Presumably, this is when Bain would have got a close look at both 3Com and H3C and the opportunity the businesses presented to create value.

At the time, Huawei agreed a non-compete agreement with its former subsidiary for 18 months. This means Huawei would have started competing with H3C in 2008. By bringing Huawei in as a minority partner on the 3Com deal, Bain has ensured alignment of interests between itself and Huawei on the future of the business.

It is not clear whether 3Com initiated a broad-based auction although other financial sponsors and strategic investors like Nortel are reported to have looked at the asset.

ô3ComÆs board thoroughly reviewed several strategic alternatives and agreed that BainÆs offer was in the best interest of shareholders, employees, customers and partners,ö says 3Com spokesperson, John Vincenzo.

In an analyst call post-announcement, one analyst benchmarked the $2.2 billion valuation of 3Com to the price of $882 million 3Com paid for 49% of H3C, which translates to an equity value of $1.8 billion for 100% of H3C. The analyst suggested stripping out the $1.8 billion H3C valuation - which accounts for $4.50 of the price Bain is currently paying - thus the residual 3Com businesses have been valued at only around $0.80 per share.

But the 3Com CFO replied that this was not the appropriate way to view the valuation as ôboth transactions have to be looked at as two independent eventsö.

Goldman Sachs advised 3Com and provided a fairness opinion.

In a separate development, 3Com shareholder Lawrence Fisk filed a suit against 3Com on Friday in Delaware Chancery Court saying the price agreed does not fully value 3Com.

ôWe arenÆt commenting publicly on this matter at this time,ö says 3ComÆs Vincenzo, with respect to the court case.

Comments on the deal at BainÆs end were made by the firmÆs Hong Kong-based managing director, Jonathan Zhu, reinforcing again that the deal was driven out of Asia.

The majority of 3Com revenues are derived from enterprise networking. 3Com has been going through tough times and its revenues have fallen from $1.5 billion in 2002 to around $795 million in 2006. The decline is due to rapid technological change, which is making some 3Com core network connectivity products obsolete.

3Com revenues in 2007 are expected to be around $1.3 billion (with China now accounting for about half), but losses have also grown. 3Com recently reported a net loss of $18.7 million for the quarter ended August 31, up from $14.1 million for the corresponding quarter of 2006.

The deal has been transacted at an equity value to trailing sales multiple of 2.77 times. On forward sales for 2007, the multiple is 1.69 times.

As part of its restructuring to create value, 3Com has set in motion a plan to IPO its TippingPoint division which makes high-tech intrusion prevention devices. ôPrior to the close of the (Bain) transaction we have no plans to change our course of action on TippingPoint,ö clarifies 3ComÆs Vincenzo.

The final decision on the IPO is likely to rest with Bain, since it will be in the driverÆs seat by the time the IPO is due to come to market. Specialists suggest Bain is likely to proceed with the IPO, both to unlock value and to make 3Com more focused. Stanton Crenshaw Communications, representing Bain, did not respond to requests for clarifications.

But sceptics continue to believe 3Com, even in the hands of private equity firm Bain and strategic investor Huawei, could find the going tough.

ôWeÆre not sure if going private solves anything and the sale to Bain Capital and Huawei may be viewed mostly as a relief than any potential long-term turnaround,ö says RBCÆs Sue, who remains pessimistic on the outlook for 3Com and its ability to effectively compete with industry giant, Cisco Systems.

Luckily for Bain, SueÆs views are not shared across the board. Bain has successfully tied up debt funding for the deal via a syndicate led by Citi and including ABN AMRO, Bank of China, HSBC and UBS.

Some specialists expressed optimism that the deal signalled a re-opening of the US leveraged buyout market. Financing for LBOs has almost dried up since the liquidity crunch caused by the subprime crisis.

But it may be too early to break out the champagne. The Bain-Huawei takeover of 3Com is a US deal only on the surface. 3Com is Asia-centric with 4,600 employees - out of a total strength of around 6,000 - based in Asia. Analysts have commented that the underlying value in 3Com is its Asia business and H3C.

Asian markets remain open for business and, indeed, banks in the region are flush with cash. This is corroborated by the fact that Citi could bring Bank of China in as a member of the debt syndicate. The same dynamic does not currently hold true with respect to US markets.

The transaction still has to secure approvals in the US and regulators are expected to closely scrutinise HuaweiÆs part in it, as the government is sensitive to foreign ownership of communications networks. Specifically, there are concerns that Huawei will have access to anti-hacking software 3Com sells to the US government. Specialists said that specifically how Bain elects to re-constitute the 3Com board and how much control Huawei will exercise could be tricky.

HuaweiÆs participation in the deal is significantly value-enhancing for 3Com, thus is seen as critical to the deal. Sources close to the deal are confident that regulators will understand the rationale and approve it.

3Com shares have fallen on the Nasdaq from peak levels of around $100 in 2000. For shareholders, including 3Com's largest shareholder, hedge fund Citadel who built up a 9.8% stake in 3Com earlier this year, BainÆs announcement was a godsend. The shares gained 35% on Friday, September 28 to close at $4.94 although it was trading a little weaker on October 1 and marginally shed some gains in early trading.