<THE RULE BREAKER PORTFOLIO>
What Happened to Fool Port?

3Dfx Goes Flat?
It's now making boards. Plus, @Home's valuation.

by Jeff Fischer (TMFJeff@aol.com)

Paris, France (Dec. 14, 1998) -- We have a grab-bag of goodies today, so let's start grabbing. First, we'll cover market news; second, @Home's valuation; and third, general Foolishness.

The News

Imagine the spine-tingling music before a nightly news report: DA DA da DUM, da da DUM DUM da DUM...

The oval office is safely empty, with Clinton wandering the Middle East, but the stock market declined anyway. Friday's news that the House Judiciary Committee approved articles of impeachment didn't excite the stock market: the S&P fell over 2%, Nasdaq dropped 3%, and the Rule Breaker dipped 1.5%.

Amazon.com (Nasdaq: AMZN) kept our Ship of Foolish stocks afloat for most of the day, rising like a humpback whale to the surface while all other stocks drowned, until the afternoon when it tired and sank, too. The online retailer benefited from news that it'll be added to the Nasdaq 100 index -- this holds the 100 largest companies on Nasdaq by market value. Anyone mirroring the index will need to reweight and buy Amazon.com.

The news that jumps off your screen and into your lap comes from 3Dfx (Nasdaq: TDFX), but now it appears that 3Dfx is goin' flat. The company announced plans to acquire computer board manufacturer STB Systems (Nasdaq: STBI) in a stock-for-stock purchase.

STB owners will receive 0.65 shares of 3Dfx for each share they hold. This values STB at $141 million -- as of Friday. Before today, STB had trailing 12-month sales of $271 million, with profit margins of 4%, all of which earned it a market value of $76 million. The company was expected to earn $1.10 per share in 1999, up 87% from last year, and it posted a loss today. This deal should close in March next year. On the news, shares of STB soared, while 3Dfx flopped. Why?

Because we own 3Dfx.

Actually, nooooo... but, in part, because our company is acquiring a manufacturing firm, thereby moving beyond its core competency while threatening to lower its operating margin significantly.

So why is 3Dfx acquiring, essentially, an add-in computer board maker?

Because it wants to control its own destiny. Imagine that Iomega didn't manufacture its own Zip drives, but instead relied on others and was at the whim of their capacity? That's akin to the situation 3Dfx is currently in: relying on others to put together its product. The company said "This shift in our business model allows [us] to control our own destiny and positions 3Dfx as one of the top suppliers of graphics technology in the world.'' From the press release, this deal will:

  • provide PC manufacturers and retail customers with a single source for 3Dfx add-in-boards with greater price stability and smoother product transitions.
  • provide high-capacity, high-quality and reliable manufacturing capabilities as a pre-qualified supplier to the top ten PC-OEM manufacturers.
  • allow for a very tightly integrated chip, software, and board-level layout and design for faster time to market and the most cost-effective graphics solutions

3Dfx was expected (read: Giant Guess) to earn $0.67 per share next year (down 24%), so let's see where that number drifts in the coming weeks. What we're most happy knowing is that PCs are beginning to be sold with 3D cards included -- without them, you can't play half the new games; and without 3Dfx specifically, you're stuck picking and choosing compatible games for your non-3Dfx card. None of this is changing. Except, now 3Dfx is Breaking its own Rules: it's reconfiguring its business for both chip design and board manufacturing, with the hope of truly dominating in its niche and calling its own shots from start to finish (again, perhaps akin to Iomega).

The recent insider buying and selling at 3Dfx doesn't tell you much. It's balanced. The 3Dfx message board is actually the largest resource of knowledge about the company, offering ongoing discussion which includes this excellent summary view of today's news from a 3Dfx-following Fool.

Also, tonight the Fool interviewed the CEO of 3Dfx, Mr. Ballard, in the Evening News. If you're interested, be certain to read tonight's Fool on the Hill interview with 3Dfx, written by TMF Puck.

Elsewhere in the Rule Breaker Port, almost only Foolish Four stocks -- including DuPont (NYSE: DD), which rose on an analyst upgrade -- fared the storm well. Starbucks (Nasdaq: SBUX) also treaded water during much of the day's hurricane.

@Home's Valuation

Last Monday, the initial version of my Rule Breaker column had valuation figures for @Home (Nasdaq: ATHM) that were in error because I'd been off by one zero in calculations. When dealing with hundreds of millions to billions of dollars, one zero means a great deal! The column was quickly corrected, but there wasn't a chance to run through all of the numbers again that night. We'll do that now, taking a fresh look at @Home's market price and the stock's potential value on a subscriber-based valuation model.

Although one of the precepts behind Rule Breaking is that near-term valuation isn't very important (that's one of the principles to Rule Maker investing, too), valuation is very instructive to consider, and potentially beneficial if addressed Foolishly. This means: don't profusely sweat over a stock's value, but do try to know it and understand it where possible.

The stock market attempts to value companies on their performance a few years from now (if not several), and when investors are in a good mood, they give leading companies more lee-way for success. For example, with Amazon.com (Nasdaq: AMZN) the market is trying to determine how large the eventual market can be for the leading online retail company. Its business can extend well beyond books to videos, music, software, toys, and so forth.

In much the same way, @Home is being valued on results expected to occur about two years from now. As current estimates come to fruition (or don't), the stock will react accordingly. If the company's business expands more rapidly than expected (as happened with AOL), the stock will appreciate faster to account for everyone's newly-revised expectations. Every quarter (or ever day, really) stocks are adjusting for the next few years of possibility. So if we find that today's value accounts for two years of growth for a company, six months from now we'll find the same thing: a stock accounting for two years of growth from that date. It never stands still. Hence, price targets are Wise.

Onto valuing @Home.

We're using the same model (linked above) that we always use to value AOL and that is used to value cable companies. The average cable TV subscriber is valued at $2,000. The average AOL member is only worth $1,400 because simple alternatives to AOL exist. However, @Home doesn't face serious competition in high-speed Internet access and it has incredibly low member turnover, so its members are valued at a higher rate. As we said last week, we'll value an @Home subscriber at $1,800 apiece.

It's estimated that @Home will have 1 million members by the end of 1999 and 5 million by 2001. This is based on the number of homes that will be capable of handling @Home services by then (about 21 million homes by the end of 1999, it's estimated, up from 13 million this year), and it doesn't include upside potential from the television set-top market, which will first be addressed next year. One million members multiplied by $1,800 apiece is $1.8 billion in value. Five million members multiplied by the same is over $9 billion in value. The company is currently valued at $8 billion.

We haven't included @Work accounts, however, nor the advertising and commerce side of the business -- one of the most lucrative for AOL. The average @Work account generates $900 per month in revenue, so its potential lifetime value is obviously much higher (22 times higher) than an average @Home account. The company has 1,600 @Work accounts signed to date, and 2,400 by next year and 3,200 by 2001 is possible. These corporate accounts could have a lifetime value of $39,600. This is potentially worth about $127 million in value two years from now. The much greater value, though (as with AOL), is in commerce and advertising deals.

This high-margin revenue is often given a value of 20 times sales -- that's the multiple the market often grants ad revenue. @Home should have over $4 million in ad revenue this year, nearly $16 million next year, and potentially $35 million by 2001. Multiplied by 20, this creates another $700 million in value by 2001 -- for a total of about $827 million in value from these two businesses before 2001. Adding this to over $9 billion in its membership valuation, @Home might approach a subscriber-based total valuation of $10 billion by 2001, or 25% above its current $8 billion price. This wouldn't mean that @Home will rise 25% and stop, though. One year from today it should be priced on what's expected by 2001, not 2000, and so on.

Hopefully this sheds some light on the valuation of the company -- and others like AOL and Yahoo! (with about 30 million registered users, Yahoo! is king on this measure). We go further to describe Internet valuations in the Fool's Industry Focus 1999, available soon. Meanwhile, to discuss Rule Breaker investing, please visit the new Rule Breaker message board.

General Foolishness

Be sure to check out TMF Runkle's Drip Port column on investing in "franchise" businesses, continued from last week. Great stuff. And -- like me -- do you have no idea what you'll buy anyone for the holidays? Click that mistletoe at the top of this page, Fool! FoolMart has great ideas to help your friends and family become Foolish, and we can all use more Foolishness in our lives, surely.

Speaking of such, the Rule Breaker Port should have a new buy to announce... tomorrow!

Fool on!


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Bookmark Live Rule Breaker Port Quotes

12/14/98 Close
Stock  Change    Bid 
 ---------------- 
AMZN  -  3/4  222.25
AOL   -2 3/16  89.50
T     -1 9/16  68.50
ATHM  -2 3/8  65.63
DJT   -  1/8    4.06
DD    +1 11/16 53.88
XON   -  3/16  74.44
IP    +  11/16 41.56
IOM   -  3/16   6.69
LU    -5 5/16  93.69
SBUX  -  11/16 49.50
TDFX  -3 7/16  12.94
 
 
                 Day   Month    Year  History  Annualized 
   R-Breaker     -1.54%   6.48% 120.46%  639.86%   58.27%
        S&P:     -2.17%  -1.93%  17.60%  148.95%   23.28%
        NASDAQ:  -3.08%   0.89%  25.25%  173.11%   25.92%


    Rec'd    #  Security     In At       Now      Change
   8/5/94  1100 AmOnline       1.82     89.50    4823.80%
   9/9/97   440 Amazon.com    19.74    222.25    1026.02%
  5/17/95  1960 Iomega Cor     1.28      6.69     422.29%
  10/1/96    84 LucentTech    23.81     93.69     293.51%
  8/12/96   130 AT&T          39.58     68.50      73.08%
  4/30/97 -1170*Trump*         8.47      4.06      52.03%
  12/4/98   450@Home Corp.    56.08     65.63      17.02%
  2/20/98   200 Exxon         64.09     74.44      16.15%
  2/20/98   215 DuPont        59.83     53.88      -9.96%
   7/2/98   235 Starbucks     55.91     49.50     -11.46%
  2/20/98   270 Int'l Pape    47.69     41.56     -12.85%
   1/8/98   425 3Dfx          25.67     12.94     -49.60%


    Rec'd    #  Security     In At     Value      Change
   8/5/94  1100 AmOnline    1999.47  98450.00   $96450.53
   9/9/97   440 Amazon.com  8684.60  97790.00   $89105.40
  5/17/95  1960 Iomega Cor  2509.60  13107.50   $10597.90
  10/1/96    84 LucentTech  1999.88   7869.75    $5869.87
  4/30/97 -1170*Trump*     -9908.50  -4753.13    $5155.38
  12/4/98   450@Home Corp. 25236.13  29531.25    $4295.12
  8/12/96   130 AT&T        5145.11   8905.00    $3759.89
  2/20/98   200 Exxon      12818.00  14887.50    $2069.50
  2/20/98   215 DuPont     12864.25  11583.13   -$1281.13
   7/2/98   235 Starbucks  13138.63  11632.50   -$1506.13
  2/20/98   270 Int'l Pape 12876.75  11221.88   -$1654.88
   1/8/98   425 3Dfx       10908.63   5498.44   -$5410.19

                              CASH  $64208.05
                             TOTAL $369931.86
  
 

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