The 3Com Deal, Behind the Security Flap

By staff reporters Ming Shuliang in Beijing, Xu Ke in Hong Kong, and Chen Zhu in Washington 

Based on the chorus of opposition in Washington, the proposed buyout of U.S. communications networking company 3Com seems even more unsettling to the American public than China National Offshore Oil Corp.’s attempted purchase of California-based Unocal – a deal that collapsed two years ago under pressure from the U.S. Congress. 

3Com’s proposed sale to China’s Huawei Technologies and the U.S. private equity fund Bain Capital “goes right to the heart of cyber security,” declared Republican congressman Duncan Hunter during a recent CNN interview. 

Congressman Thaddeus McCotter, chairman of the House Republican Policy Committee, wrote to fellow House members, “We must tell the communist Chinese that America’s security is not for sale.” And several organizations, including the virulently anti-China group China e-Lobby, wrote to Gay Hartwell Sills, staff chair for the Committee on Foreign Investment in the United States (CFIUS), a Treasury Department agency, asking her to block the deal. 

Bain and Huawei announced September 28 their intent to jointly acquire 3Com for US＄ 2.2 billion. Bain would control 83.5 percent of 3Com stock, Huawei the rest. The 3Com board has accepted the deal and scheduled closure by the first quarter 2008, pending shareholder and regulatory approval. It would be the largest-ever foreign acquisition by a private Chinese enterprise, unless opponents derail the process. 

The opposition claims the deal would compromise U.S. national security, pointing to the supposed threat posed by a 3Com subsidiary named Tipping Point that’s done business with the U.S. government. But the companies, analysts and other supporters say the buyout would not compromise Washington’s security but, in fact, makes business sense – particularly since a profitable Chinese company called H3C is 3Com’s main subsidiary and the chief target of the buyout. 

In a statement for , privately held Huawei declined to directly respond to the security question. Rather, the statement called the deal “our business investment” and stressed that the proposed partnership with Bain – a fund founded by U.S. presidential candidate Mitt Romney – would give it “a minority share of 3Com.” 

3Com is a provider of network infrastructure that was once a leader in the sector but fell on hard times after the burst of the dot-com bubble. Boston-based Bain is one of America’s leading PE funds, managing assets worth more than US＄ 50 billion. And Huawei is a Chinese manufacturer of telecoms equipment that, powered by the rapid growth of its domestic market, has become a competitive, international force. 

Security Threat: Real or Imagined? 

It’s become quite clear that 3Com is barely in a position to continue independently. At one point in 2000, 3Com’s share price stood at more than US＄ 20. Today, the Bain-Huawei acquisition price of US＄ 2.2 billion is equivalent to US＄ 5.30 per share -- a premium that’s 44 percent above market valuation. 

3Com’s first quarter report for fiscal 2008, released in September, put the company’s quarterly sales volume at US＄ 319 million -- a mere 5 percent of the market for small- and medium-sized enterprises in the digital network communications field.  

“3Com may end up being a business school case study in what not to do,” wrote RBC analyst Mark Sue in a comment that the company may find unpleasant but, given its declining fortunes, can hardly refute. 

Nevertheless, from the start Huawei’s offer was tainted by security issues surrounding 3Com and its network security company Tipping Point, which it bought in 2004. The Washington Times, a conservative U.S. newspaper, claimed that a number of U.S. government agencies, including the Department of Defense, were Tipping Point clients. Tipping Point developed products to prevent network intrusions that can distinguish legitimate and malicious data packets in network traffic, thus warding off potential attacks. 

Neither was Huawei’s effort helped by an anonymous Pentagon official’s charge that hackers from the Chinese military had compromised the Pentagon’s computer network in June. The accusation appeared in the western press, including Britain’s Financial Times, in early September. Although Chinese authorities dismissed the claim as baseless, the news could “hardly have come at a worse time” for the proposed 3Com buyout, said one source close to the deal. 

Moreover, Huawei founder and current CEO Ren Zhengfei formerly served with the People’s Liberation Army. Ren’s background, together with stories about businesses Huawei developed in Iraq and Afghanistan, as well as the company’s intellectual property rights disputes with Cisco Systems in 2003 and ’04, were repeated in the western media, which played up and speculated over the story.  

The fact that the principal buyer, Bain, was an American fund did little to quiet public debate over the proposed acquisition. Meanwhile, Bain and 3Com submitted October 4 an application for a national security review of the deal by CFIUS, an agency set up in 1988 to investigate foreign financial investments that pose potential security threats to the United States. CFIUS conducted checks on Lenovo’s successful 2005 purchase of IBM’s personal computer business and CNOOC’s failed bid to buy Unocal. 

”Any deal involving China, if it has links to information systems used by the American government, will come under scrutiny from CFIUS,” Christopher Simkins, a lawyer with the firm Covington and Burling, and formerly with the U.S. Department of Justice, told . “This is still the case even when the Chinese investor is to be a minority stockholder.” 

The Bain-3Com security application claimed their deal would have no effect on America’s national security. Huawei would not gain any right to manage or run 3Com, nor would the Chinese company gain access to sensitive technology or U.S. government contracts. All 3Com sales to U.S. government agencies went through franchisees or system assembly businesses; the company never had any direct business dealings with the government. More importantly, the application said, “3Com’s main clients are small- and medium-sized enterprises. The products 3Com sells to government agencies are of commercial products available on the open market. The company has no specially made products by order of a U.S. government agency.” 

The security application also said 3Com planned to spin off Tipping Point, the subsidiary at the center of the controversy, as a public company in 2008. 3Com ran Tipping Point as a separate entity without blending its assets and operations with other parts of the company. In the quarter just before the 2004 takeover, Tipping Point’s total sales amounted to less than US＄ 20 million and the company had yet to make a profit. 

Few in the business world saw any reason for the deal to fail a security check. Industry analysts were generally optimistic. Manuel Recarey of the U.S. investment firm Kaufman Brothers told , “There is no way CFIUS will stop this deal over information security issues because 3Com has never sold sensitive products to the Department of Defense or intelligence agencies.” 

And a contract awarded in Iraq appears to support Huawei’s claim that U.S. decision-makers need not be concerned. The company won a US＄ 275 million deal earlier this year to provide a national wireless network for Iraq’s state-owned telecoms provider Kalimat. 

The Buyout’s Real Target 

Morgan Stanley’s John Marchetti, speaking with 3Com CEO Edgar Masri during a conference call of senior managers and analysts shortly after the deal was announced, said that Masri “mentioned the valuation of US＄ 5.30 being very, very reasonable. And I’m just curious....” 

Marchetti’s curiosity had substance. Last March, 3Com had become the sole owner of Huawei’s networking joint venture, H3C. 3Com paid US＄ 882 million for the 49 percent of the company that it did not already control, implying that the overall value of H3C was around US＄ 1.8 billion, or US＄ 4.55 a share. 

Marchetti wanted to know whether the US＄ 5.30 figure meant that the rest of 3Com’s business outside H3C was worth only around US＄ 0.75 a share, or US＄ 400 million. 

3Com senior managers did not directly answer the conference call question. Others outside the company, however, were happy to say that, indeed, this was an accurate summary of the financial picture. Perhaps the real point of Marchetti’s question was to make 3Com management feel a little awkward. The price trend for 3Com shares has made no one happy in recent years. What was absolutely clear was that Bain’s real target was neither Tipping Point, whether spun off or not, nor 3Com’s North American voice and data business, which has lost money, has poor prospects and has been shrugged off by analysts as a “dismissed business.” The real target of the acquisition was H3C. 

Hong Kong-registered H3C, headquartered in Hangzhou, in Zhejiang Province, accounted for half of 3Com’s 2007 sales of US＄ 1.3 billion and all its gross profit. H3C is the only reason why 3Com is still able to compete on an equal footing against Cisco in China’s market for digital communications equipment. CCID Consulting ranked the Huawei-H3C team first in China’s digital communications equipments market in 2006 with total sales of 7.9 billion yuan. Cisco ranked second with sales of 6.6 billion yuan. 

H3C was formed in November 2003 principally to provide enterprise-level routers and network switches. At the time, 3Com’s then-CEO Bruce Claflin said his company was providing money for the joint venture’s operations in the Greater China and Japan markets, while Huawei was providing technology, products and staff. 

Jonathan Zhu, Bain’s managing director for Asia, told that “H3C’s success was based on their access to Huawei’s Versatile Routing Platform (VRP) technology. They didn’t use 3Com technology. Huawei is a net exporter of technology, not an importer. If the Americans are talking about precious technology falling into the hands of a Chinese company, it’s because they don’t know the facts.” 

H3C’s stock value has risen with each of three changes in its shareholder structure. Shares were originally split 51 percent for Huawei and 49 percent for 3Com, but their joint venture agreement gave the latter the right to buy another 2 percent of stock from Huawei at any point over the following two years, for a controlling stake. 

The joint venture’s launch came shortly after Huawei’s founder Ren said his company would need to “prepare itself to hunker down and survive winter.” That’s because Huawei, founded in 1988, had not escaped the troubled aftermath of the dot-com bubble burst. It turns out that a liquidity problem was the real reason why Huawei did not put more cash into the joint venture. 

A still bigger threat for Huawei -- or at least a greater threat for Ren, with his hands on the reins -- was that his former subordinate Li Yi Nan had created a company called Harbor Networks. Everyone at Huawei considered Li a technical genius. He had been made the group’s deputy CEO at age 20 and, at one time, was considered Ren’s possible successor. But in 2000, Li decided to set up business for himself. He began by selling Huawei products as an agent. He then developed his own line of routers, switching gear and other equipment. Supported by venture capitalists like Warburg, Harbor grew quickly and, by 2003, annual sales broke the 1 billion yuan barrier. 

For an ambitious company like Huawei, the long-term aim should have been to catch up with major competitors such as Cisco and Nortel. But instead, the newly formed and fast-moving Harbor emerged as a true rival. If Harbor succeeded in going public, Huawei’s corporate culture could have received a mortal blow. 

For a long time, almost every Huawei move was aimed at containing Harbor. The joint venture with 3Com was no exception. Enterprise-level routers and switching devices were not mainstream products for Huawei, as the company instead focused on research and manufacturing communications equipment for telecom networks. By separating its enterprise-level digital communications network business through the 3Com venture, Huawei could concentrate its own limited resources and harness an ally for its contest with Harbor. H3C would make a flank attack in the market for the same products at the core of Harbor’s business. It was a clever move, and it succeeded even beyond Huawei’s dreams. 

H3C’s sales earnings for 2006 were US＄ 712 million, helping the company maintain record, year-on-year growth of around 70 percent for three consecutive years. More than half of the company’s 5,000 staffers were researchers. 

Winter passed for Huawei. After sales fell in 2002, the company rebounded strongly in 2003, as sales rose 50 percent year-on-year to 31.7 billion yuan. By 2006, sales had climbed to 65.6 billion yuan, with overseas sales accounting for more than 44 percent of the total. With the global telecoms equipment market stagnant, Huawei had staked a place in the sun by dominating an emerging market. It was now able to compete on the world stage as an equal to the best. 

In early 2006, 3Com exercised its right to buy the agreed-upon  2 percent of H3C stock from Huawei, raising its stake to a majority 51 percent. The purchase was valued at US＄ 28 million, and H3C’s worth increased to US＄ 1.4 billion. The investment had seen a handsome return in just two, short years. 

By mid-2006, Huawei also had succeeded in containing Harbor, whose sales faltered after Huawei launched a price war that it seemed willing to wage regardless of cost. Although Huawei does not publish financial reports, a former Huawei employee said the company actually lost money during the price war in 2005. Beset by intellectual property lawsuits filed by Huawei and difficulties in completing a public listing, Harbor saw its sales peak at 1.5 billion yuan in 2005 and begin a downward slide. In the end, under pressure from investors, Harbor sold its core businesses lock, stock and barrel to Huawei. 

The downfall of its bitter rival was an unexpected boon for Huawei. With Harbor gone and no serious competition left, the way was open for H3C sales to soar, rising 50 percent in several quarters. China’s enterprise-level router and switching device market was worth an estimated 30 billion yuan, and was growing by more than 30 percent annually. 

PE firms soon started showing interest in H3C. One source told that, spurred by the arrival of private capital and prior to November 2006, Huawei and 3Com had fought a bidding war for the right to own H3C. Since their joint venture agreement only allowed one to sell shares to the other, interested PE investors could intervene only through one of the shareholders. At this point, Bain already was hoping to collaborate with Huawei in a plan for Huawei to buy 3Com’s 51 percent stake, then sell 80 percent of those holdings to Bain, retaining a 20 percent interest in H3C for itself. 

The source said, “The bidding war means I name a price, you better it, I offer even more, and so on, until one side drops out and the last bid is your price.” 

3Com made the first bid on November 16, 2006. By the 29th, the two sides had reached agreement: Huawei would sell its 49 percent stake in H3C to 3Com for US＄ 882 million, setting the company’s value at US＄ 1.8 billion -- up 30 percent from the US＄ 1.4 billion valuation cited at the beginning of the year. 

Basically, 3Com would not exist without H3C. In addition to accounting for all 3Com’s gross profit and half its sales in fiscal 2007, H3C grew 50 percent for several quarters, and its 4,500 employees comprise 80 percent of 3Com’s workforce.  

Huawei did not have to worry about keeping or losing a stake in H3C, which was not part of its main business. But H3C was a matter of life or death for 3Com. So although the bidding went through several rounds, the conclusion was never in doubt. 3Com’s victory was finalized the following March. 

Capital’s Worth in the Right Hands 

Although 3Com had won its prize at great cost, Wall Street was not impressed. One analyst after another lowered forecasts for 3Com, reasoning that H3C’s success was dependent upon Huawei and that, once separated from the Chinese partner, its performance was likely to suffer. The analysts were right. 

The vast majority of H3C’s thousands of employees originally came from Huawei, with 3Com providing fewer staff members, except for board chief Masri and senior managers including a chief financial officer. The key business was entirely in the hands of a management team that came from Huawei. Huawei was itself H3C’s largest customer, accounting for 30 percent of the company’s sales. H3C relied on Huawei in the smallest details, even renting its headquarters in Hangzhou from Huawei. All this and more was clearly set out in the “potential commercial risks” section of 3Com’s public financial reports. 

From the moment the shares changed hands and a clean break had been made, the stage was set for Huawei’s future, just as 3Com CEO Edgar Masri later admitted. The agreement for 3Com’s takeover said that after 18 months – that is, by September 2008 -- Huawei would no longer be restrained by a non-competition clause and could begin an untrammeled entry into H3C’s enterprise-level, digital communications equipment market. Also, former Huawei managers and staff working at H3C could return to their former employer should they so desire. 

“When the time comes, Huawei will likely become a competitor,” according to a 3Com report submitted to the U.S. Securities and Exchange Commission. But that was not all. After selling its H3C stock, Huawei was free to cut product purchases from the former partner. “If our products and services prove unsatisfactory, Huawei may well take its business elsewhere or produce these for itself,” the report said. 

Although the report cited only potential risks, in reality H3C’s performance had already been affected. During the conference call with 3Com managers, Morgan Stanley’s Marchetti closed with a question that left the bosses at a loss for words: “Did you feel that it was more difficult than you had originally anticipated to run the H3C business on your own?” 

“Capital is worth more in the right hands,” another analyst concluded. It’s the same principle expressed 2,200 years ago by Chinese statesman Lu Buwei in the Spring and Autumn Annals: “Plant an orange tree north of the Huai River and it will bear bitter fruit; plant it south of the river and its fruit will be sweet.” 

3Com’s first quarter report for fiscal 2008 said H3C sales grew just 10 percent year-on-year. Senior managers tried to explain away this modest growth by saying that integrating the two companies would take time. But since Wall Street wants results, 3Com’s shares fell steadily until, on the eve of the latest takeover announcement, they slumped to an all-time low below US＄ 4 per share. 

Bain’s Investment Strategy 

Bain would have preferred to buy H3C separately by collaborating with Huawei in 2006. But the PE investment firm was happy enough to bet on 3Com a few months later. A source close to the buyer said, “Our target was getting H3C.” After direct talks with 3Com went well, Bain moved in for the kill and sealed the deal within two months. 

Bain has a colorful history. Its founder Romney parted ways with the 23-year-old firm to enter politics in 1999, later serving as chairman of the 2002 Salt Lake City Winter Olympics and  Massachusetts governor from 2002-06. Bain’s better-known deals through the years included purchases of office supplier Staples and the Domino’s Pizza franchise, and investments in retailer Toys R Us and fast food’s Burger King. Recently, it has invested large sums, with a number of acquisitions worth more than US＄ 10 billion. 

Until recently, Bain was not particularly well known in China, although it had made a number of moves reflecting its investment style and a desire to team up with an emerging Chinese powerhouse. Two years ago, Bain worked with private equity’s Blackstone Group and China white goods giant Haier in a billion-dollar bid for Maytag, a U.S. appliance manufacturer. Bain and its partners ultimately lost to a higher bidder, appliance maker Whirlpool. 

China Telecom planned in 2006 to team up with Bain to buy Luxembourg-based Millicom, a provider of mobile telecom networks in a number of countries and a major target for China Telecom’s overseas expansion. It would have been the largest acquisition ever for a Chinese company, but China Telecom pulled out unexpectedly at the last minute. 

Bain manager Jonathan Zhu, 43, joined the firm in 2006 after several years as head of Morgan Stanley China. He was working for his old boss as Huawei’s financial advisor when Huawei and 3Com created their joint venture in 2006. 

Bain’s strategy appeared to pay off when it finally joined Huawei to buy 3Com. It was a sensible strategy. Newly emerging Chinese capital seeking to expand through overseas acquisitions has been subject to a number of stumbling blocks, including a lack of prestige outside China and difficulties in persuading sellers to close deals. 

Making sure a potential buyer comes up with cash is a prerequisite for any acquisition. This is where PE funds can help Chinese companies. A PE-purchaser partnership can improve chances of obtaining bridge loans from banks. Without such a partnership, even large Chinese companies such as Haier – which are still quite small by international standards -- find it difficult to obtain bridging loans on favorable terms. 

A source close to the deal team said Bain and Huawei received some US＄ 1 billion in loans from Deutsche Bank, Credit Suisse, HSBC, ABN AMRO and the Bank of China. Domestic emerging industrial capital also brings clear value to a deal. As China’s manufacturing industries continue to grow, acquiring brands and markets, and supported by the ability of Chinese enterprises to keep costs low, they clearly become part of a sensible strategy for investors. Examples include the giant PE fund Texas Pacific Group’s investments in IBM and Lenovo, and the collaboration between Bain and Haier. 

Bain was certain that it would be best to partner with Huawei for the proposed acquisition of 3Com. Bain stuck to its policy to work together with Huawei, first by backing Huawei in its bidding war for H3C and later in the battle for 3Com. 

“Some say Huawei got Bain to buy 3Com for them, but that’s completely wrong. It was Bain that begged Huawei to come in on the deal, not Huawei looking to get 3Com,” said one source close to the acquisition team. 

A Win-Win Situation for Huawei  

Time will tell whether Bain benefits from the proposed takeover of 3Com. But without question, Huawei is already a winner.  

Communications equipment industry watchers generally agree that this proposed deal is not big enough to directly impact industry leader Cisco. But they are divided over the impact of 3Com’s change to a private from a public company. Some argue that 3Com will be more flexible with strategizing and under less pressure if it is not required to issue financial reports. Others think 3Com’s sorry track record and bad decisions militate against hopes for the company’s future. 

One point that all agree on is that H3C’s renewed ownership link to Huawei is a positive factor. has learned that, if the acquisition goes through, a no-competition agreement between H3C and Huawei in terms of sales and staff will be extended past its current September 2008 deadline. 

Tipping Point’s future will most likely be decided according to whatever helps the acquisition receive CFIUS approval. 3Com’s original plan to spin off Tipping Point now seems the least contentious arrangement. A source close to the deal told that a spinoff is “most likely.” The only remaining issue is when would be the best time for Tipping Point to go public, as the company has yet to make a profit. 

Lee Imin, an industry expert and president of the Hua Yuan Science and Technology Association, told she sees no need for American security concerns over the sale of Tipping Point. “All you need to do is find a third party to act as public notary,” she said. 

However, Lee thinks the market for exclusive network security software is too narrow. Lee was a founder of network security software developers Protego Network, which used to be a direct competitor to Tipping Point. She later sold the business to Cisco in 2005 for US＄ 6.5 million. 

Lee is sanguine about Tipping Point’s future prospects. In her view, the market for packet analysis technology aimed at preventing network intrusions has been shown to be very small. This specialized technology needs to be included in a suite with anti-virus and terminal software. Spinning off Tipping Point as a stand-alone business doesn’t make much sense, she said. 

3Com’s data network business in North America has been squeezed by Cisco and smaller competitors such as D-Link and Netgear. It is a money-loser, with no growth momentum and a bleak future. But this is the kind of firm that attracts PE funds, which work with companies that need radical surgery. Thus, the data network aspect of 3Com’s business appears ripe for the chop. 

“We believe, with business restructuring, 3Com will be able to provide better products and services to customers as well as bring added value to customers,” Huawei’s statement said. “Huawei decided to participate in this acquisition of 3Com in an attempt to build a strategic partnership with 3Com, and thus to enhance Huawei’s capacity for end-to-end business project solutions.” 

In the final analysis, the future of H3C will be determined by the success of this acquisition, as long as company retains close ties to Huawei. asked a source close to the deal how the buyers planned to ultimately disengage the two firms in a way that makes money. The answer was vague. “Maybe we’ll sell it on, maybe we’ll let it go public,” the source said. In either case, with H3C’s success so dependent on its close ties to Huawei, who would dare come between the two? 

Whether Bain emerges a winner will depend on how such uncertainties are resolved. But Huawei has already benefited from each of three H3C ownership changes. H3C’s asset value alone has increased from US＄ 160 million when it joined 3Com in the joint venture, to US＄ 1.4 billion when it sold a 2 percent stake to its partner, to an estimated US＄ 1.8 billion today. Huawei has done very well indeed. Its participation in this acquisition can be seen in one sense as buying back its former assets at a lower price. 

If the security debate is resolved, and the proposal wins shareholder and regulator approval, Huawei’s influence over H3C and 3Com would extend far beyond that of a simple stockholder. It plans to hold three seats on a future 3Com board and, according to the Huawei statement, “3com will be a business and strategic partner.” 

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