3Dfx Needs a Caning
... what else might whip it into shape?
by Jeff Fischer
ALEXANDRIA, VA (Aug. 10, 1998) -- This morning 3Dfx announced that Gateway is offering the company's Voodoo2 chipset on some of its personal computers, making Gateway one of the first PC makers to offer 3Dfx (Nasdaq: TDFX) technology as an option. The company announced three weeks ago that Voodoo was available on other models, too, so this isn't exactly "new" news.
Yet, the timing of the announcement is apropos because today's column will review 3Dfx. It also seems an appropriate day to review the stock because, once again, it declined on good news. We believe that this equity did not go to behaviorial training school. In fact, it either doesn't know how to react to good news (perhaps it has low self-esteem and shies from success), or else it knows exactly what it's doing and it has self-destructive tendencies. Perhaps 3Dfx enjoys rebelling against the expected and the status quo. Every single time that the company announces good news, the stock declines. The better the news, the more the stock declines.
Before we psychoanalyze this baffling patient, however, we have other business to attend to. While my assistants are putting 3Dfx in its straight jacket and sedating it (not that it needs to be any more sedated), let's consider another basket case: the stock market. The U.S. and world markets are less predictable than an armadillo caught in a pick-up truck's headlights on a Texas highway in the rain. Will the beady-eyed little guy run left for the brush, or right towards the ravine? Or will it stand -- frozen -- in the middle of the road?
The S&P 500 did all three today -- it ran up, ran down, stood still -- and finally ended the day down 0.58%. The Fool Port began slowly but ended the day ahead by 1.65%, taking the checkered flag after lapping the competition three times.
There was little news aside from America Online (NYSE: AOL) announcing a deal with AdForce, Inc. that relates to ad management services. By the way, AOL's ad and commerce revenue backlog climbed to over $510 million last quarter. That's a lot of higher-margin bacon for a young company that now has its network largely in place and has fixed costs that are in general beginning to level out. Beyond this, reportedly AOL is building a portal website for its CompuServe division at http://www.compuserve.com, something like its AOL.com portal. No big surprise.
Other than that -- zippo news. At least, zippo that we deem worth reporting. The next event that we anticipate is the loss announcement from Trump Hotels (NYSE: DJT) that might be announced on Wednesday. The company is known to push its announcement date around -- hey, its gotta be able to bully something around in its otherwise flailing business.
In our methodical review of each Fool stock, it's time to consider our second-most recent purchase. Yes, the mysterious 1700s and 1800s live on, for this is a company that makes money selling Voodoo.
3Dfx (Nasdaq: TDFX) Stock Price: $15 Market Cap: $230 million Trailing Sales: $175 million Price/Sales: 1.31 Last Qtr Sales: $58.6 million Book value: $6.97 per share Price/book value: 2.15 Recent return on equity: 30.7% Recent Gross Margin: 48% Recent Operating Margin: 19% 5-year est. growth rate: 30% P/E on far earnings estimate: 7.2 Earnings Est.: $2.06 in FY99What caused the Fool to buy it? Published in the first week of the New Year, the Fool buy report for 3Dfx explained how David Gardner is a computer gamer who came to know 3Dfx and its Voodoo 3D technology by actually using it. No other competitor came close to matching the performance of 3Dfx's products (as proved again by recent comparisons), yet the relatively unknown and recently public company was little followed, and the earnings estimates, David felt, were very conservative.
Chalk one up for Monsieur Gardner -- the 1998 earnings estimates stood at $0.50 per share when the Fool Port bought the stock. The new and current 1998 estimate is $1.88 per share. That's the largest rise in earnings expectations over a one-year period that the Fool Port has ever seen with any of its companies. You'd think that we'd be sitting on a respectable winner.
What has happened since the purchase? On the contrary, 3Dfx is the portfolio's second-largest loser, down a whopping 43% since January 8, while the S&P has gained 11%. Despite rising smartly after crushing first quarter earnings estimates, the stock just as quickly tumbled. We discussed possible reasons for the drop over several weeks, with lack of brokerage coverage being one potential contributor, Intel another, short selling yet another, and industry valuations finally one more. In the end, we can't say that we're Sherlock Holmes and that we've solved this case. Perhaps we should just be happy that we haven't cracked in the process of trying.
The 3Dfx message board on the Fool website is one of our most active. If you venture out there, non-shy Fools, and ask, "Why do you think 3Dfx is down 43% since January while reporting incredibly strong business and earnings?" you'll receive many informed opinions, many probably mirroring the reasons just hypothesized but with more detail.
What lessons have been learned? We're still learning them. Soon after the Fool Port buy I wrote a bearish Dueling Fools on 3Dfx trying to lay out why the company, an add-on semiconductor chip producer, could be less likely to beat the market over the long term. As Foolish investors, we always try to see both the good and bad points of our investments.
As we've already learned in the past, companies that are viewed as being in highly competitive, uncertain, and/or cyclical industries (even if the cyclical nature of the business doesn't apply directly to the particular company that you're interested in) often trade at low multiples to earnings. Disk drive makers and semiconductor stocks are prime examples. When they're hot, yeah, they can be hot. But most of the time they trade at low P/E multiples relative to the market and even relative to their growth rates. All of 3Dfx's would-be add-on chip competitors trade at around 7 times earnings -- just as 3Dfx does on 1999 earnings estimates.
Fair? Not really. But logical? Well, it makes some sense when considering the uncertainty and what has happened to companies in this business in the past. Bulls argue that 3Dfx is different, though. And yes, it might very well have carved a defensible niche for itself. In some small way, though, it reminds me a little of Iomega (NYSE: IOM). At first Iomega sold millions of Zips and then it pushed into the OEM PC market (as 3Dfx is working to do now), but when shelf retail sales slowed, so did earnings, as OEM market sales are lower margin than were sales in the go-go years of Zip's introduction. Could 3Dfx's product cycle prove similar?
What could cause the Fool to sell it? At a price of only about 2 times book value while still growing gangbusters, we're far from selling 3Dfx. The company trades at 7.2 times 1999 earnings estimates, while 1998 estimates of $1.88 per share might prove low, seeing how the company has $1.04 in earnings for the year so far, and the fourth quarter holiday season should be the strongest.
Frankly, though I don't expect a forward earnings multiple on 3Dfx of much above perhaps 20 (considering the industry), I still am surprised that it trades this inexpensively in light of such strong results and early market leadership. The company is consistently a generation ahead of the competition and has locked down gaming design agreements with hundreds of game producers. In June, the Fool interviewed the company's CEO, Greg Ballard, and he provided insight as to the future and the company's plans. We intend to be along for the ride as long as the business results are strong. Eventually the stock price might follow more in step.
A little numbers info. Please note that beginning today we're quoting all stocks in the portfolios at their closing price rather than the bid price, as we used to quote Nasdaq stocks. There are several reasons for this, including that whenever our "bid quote" differed from the closing price quoted everywhere else it confused many readers; also, the bid and ask "spread" on Nasdaq stocks have narrowed greatly over the past years anyway, removing much of our impetus for quoting the bid; and for internal production automation reasons, quoting the closing price is most logical. This tweak won't change the performance of the portfolios in any way, shape, or form on a daily or otherwise basis. It's minor, but it was worth noting for old-time readers who were used to us quoting the bid price on certain stocks.
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Day Month Year History Annualized FOOL +1.65% 1.77% 49.67% 402.30% 49.50% S&P: -0.58% -3.35% 11.61% 136.29% 23.89% NASDAQ: -0.41% -1.77% 17.12% 155.38% 26.31% Rec'd # Security In At Now Change 8/5/94 710 AmOnline 3.64 113.13 3010.88% 9/9/97 580 Amazon.com 19.11 121.63 536.42% 5/17/95 1960 Iomega Cor 1.28 5.25 310.03% 10/1/96 84 LucentTech 23.81 89.94 277.76% 8/12/96 130 AT&T 39.58 58.06 46.70% 4/30/97 -1170*Trump* 8.47 6.13 27.68% 2/20/98 200 Exxon 64.09 67.75 5.71% 2/20/98 215 DuPont 59.83 61.63 2.99% 2/20/98 270 Int'l Pape 47.69 44.00 -7.74% 7/2/98 235 Starbucks 55.91 42.50 -23.98% 8/24/95 130 KLA-Tencor 44.71 30.38 -32.06% 8/13/96 250 3Com Corp. 46.86 28.06 -40.12% 1/8/98 425 3Dfx 25.67 14.56 -43.26% 6/26/97 325 Innovex 27.71 13.44 -51.51% Rec'd # Security In At Value Change 8/5/94 710 AmOnline 2581.87 80318.75 $77736.88 9/9/97 580 Amazon.com 11084.24 70542.50 $59458.26 5/17/95 1960 Iomega Cor 2509.60 10290.00 $7780.40 10/1/96 84 LucentTech 1999.88 7554.75 $5554.87 4/30/97 -1170*Trump* -9908.50 -7166.25 $2742.25 8/12/96 130 AT&T 5145.11 7548.13 $2403.02 2/20/98 200 Exxon 12818.00 13550.00 $732.00 2/20/98 215 DuPont 12864.25 13249.38 $385.13 2/20/98 270 Int'l Pape 12876.75 11880.00 -$996.75 8/24/95 130 KLA-Tencor 5812.49 3948.75 -$1863.74 7/2/98 235 Starbucks 13138.63 9987.50 -$3151.13 6/26/97 325 Innovex 9005.62 4367.19 -$4638.43 8/13/96 250 3Com Corp. 11715.99 7015.63 -$4700.37 1/8/98 425 3Dfx 10908.63 6189.06 -$4719.56 CASH $11876.47 TOTAL $251151.84