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Monday, December 14, 1998

An Investment Opinion
by Yi-Hsin Chang

Turning Point for 3Dfx

In one fell swoop, 3Dfx Interactive (Nasdaq: TDFX) became a new company today.

"It's a huge turning point" for 3Dfx, said CEO Greg Ballard in an interview this afternoon. "It's a huge turning point, I would argue, for the whole industry."

The 3-D graphics technology company this morning announced it will acquire multimedia accelerator manufacturer STB Systems (Nasdaq: STBI) for about $141 million, or $10.64 a share in stock, based on Friday's close. That represented a roughly 84% premium to STB's closing price Friday of $5 25/32 ($5.78). But because 3Dfx lost $3 7/16, or 21%, of its value today to $12 15/16, the price is now more like $8.41 a share. Under the terms of the deal, shareholders will exchange each STB share for 0.65 of a 3Dfx share. The companies expect to complete the transaction in March.

According to Ballard, 3Dfx is leading the charge -- the "first mover" -- in a wave of industry consolidation, where every player is talking with everyone else to broker the best possible deal. "In the game of musical chairs, because we moved first, we got to pick the best chair," Ballard said. "Now everybody else is looking around and looking at which chairs are left over, and, frankly, some of them have broken legs."

Conventional wisdom has been that it's better to invest in graphics board makers that aren't bound to any one technology because they can avoid the technological "leapfrog" that invariable occurs in the business. But Ballard believes that the 3Dfx-STB combination is a better business model and is a better way of delivering products to both retail consumers and original equipment manufacturers (OEMs). The seamless operation eliminates the middleman, allowing 3Dfx to respond faster to new technologies and issues of supply and demand.

Ballard admits that the company will be going into a much lower margin business, but he emphasizes that there are a lot of margin dollars in this business. For example, 3Dfx sold Voodoo 2 technology to manufacturers such as STB for $50 apiece. STB, in turn, sold the product at retail for $250. With the STB acquisition, 3Dfx will be able to make more money on each product and thus generate more revenue.

Still, manufacturing will eat up working capital and contribute to a longer cash conversion cycle. While it's too early to say whether the deal will be accretive to earnings, at the very worst, it should be neutral to earnings, Ballard said. While no outright cost savings will result from the merger, 3Dfx is acquiring a company that trades at a lower forward P/E multiple.

One of the main reasons 3Dfx picked STB is because the board maker has established strong relationships to major OEMs. For the first nine months of fiscal 1998, about 82% of STB's net sales were to OEM customers. PC makers Gateway (NYSE: GTW), Dell Computer (Nasdaq: DELL), and Compaq Computer (NYSE: CPQ) accounted for about 75% of the total sales. In contrast, 3Dfx has only just started to cultivate ties with OEMs, which have been concerned that the company won't be able to deliver on products promised because it isn't a manufacturer. By eliminating the middleman, 3Dfx can deal directly with OEMs. At the same time, it can take advantage of STB's retail distribution infrastructure to maximize its already strong retail presence.

While 3Dfx and STB will both continue to support existing products and customers, the combined company will be the single source for future 3Dfx products, starting with Voodoo 3 early next year. But 3Dfx will continue to sell new technology to niche players such as Quantum 3D as well as some customers in Asia and parts of Europe, where its infrastructure may be lacking. At first glance, one company that stands to lose from the deal is privately held nVidia, a competitor to 3Dfx that derived 63% of its revenue last year from STB. For a company that has filed to go public, the 3Dfx acquisition of STB and the mergers that are likely to follow may leave nVidia standing without a chair.

Related Links:
-- StockTalk Interview with Greg Ballard (9/17/98)
-- StockTalk Interview with Greg Ballard (6/3/98)
-- 3Dfx message board

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