Rule Breaker To Sell 3dfx Interactive

**This trade is being made under the regular portfolio policy, namely, once The Fool announces an intention to trade, that trade will be made within the next five trading days. For more detail, please read the New Trades section of the Rule Breaker Portfolio.**

At some point in the next five market days, the Rule Breaker Portfolio will SELL 425 shares (its total stake) of 3dfx Interactive (Nasdaq: TDFX).

Transaction Stats: On December 17, 1999, the RB Port sold its 425 shares of 3dfx at $9 5/16 per share, plus an $8 trade commission. The RB Port lost nearly 60% on the investment, while the Nasdaq gained more than an equal amount. Ouch. We made a mistake.

A New Business Right Before Our Very Eyes

Even as 3dfx (Nasdaq: TDFX) dominated the high-end 3D graphics chip market, it flopped as an investment. The Rule Breaker Port has lost over 60% on the stock since its January 1998, purchase. It has been a conundrum of a performance. Initially, the company dealt earnings estimates a backhand, topping them by nearly 40% in the early going. How did the stock react? The stock usually fell on the great news. Later, on news that earnings would fall short of estimates, the stock tended to hold steady or rise. Finally, the bottom truly fell out this year when 3dfx announced earnings results well below expectations. On just one day in August, the stock tanked from $15 to $10; now it has fallen to $9 and a fraction after being as low as $7 1/2.

Circumstances and management's actions have conspired to delete 3dfx of its Rule Breaker status. Where 3dfx was once the top dog in providing gaming graphics technology to consumers (possessing the leading consumer brand and leading market share -- both of which it still does hold), the company has since become a board manufacturer, too, selling products to PC makers like Dell Computer (NYSE: DELL) and Compaq (NYSE: CPQ). In December 1998, 3dfx announced that it would buy STB Systems for about $140 million. This presented a severe shift in its business model from one of high margins and low capital expenditures to one of much lower margins, a longer cash conversion cycle, and much higher capital expenditures. Whether or not the acquisition is entirely to blame, the stock hasn't been the same since the early 1999 purchase of STB.

The best way to demonstrate how our investment has strayed from our ideal is to put the company up against the Rule Breaker criteria.

1) The top dog and first-mover in an important, emerging industry.

With the acquisition of STB Systems, 3dfx moved into the industry of board manufacturing. In the past, 3dfx marketed its technology -- a "light" endeavor. In an effort to control its supply destiny (because it had suffered chip board shortages that harmed its ability to meet demand), 3dfx became an original equipment manufacturer (OEM). In the board-making industry, the company isn't the top dog and it is hardly a first mover. More importantly, as vital as the industry is to computers, it isn't important in a Rule Breaking way, and it isn't emerging. When we bought 3dfx, the 3D graphics industry was emerging as an important new wave in computer technology. (Much of the importance, we thought, might emerge from 3D design applications in the business world, but 3dfx hasn't jumped at this market.)

Its new board business aside, a more pointed problem may be 3dfx's status as top dog in its actual field of expertise: 3D graphics accelerator performance. Although the company still lays claim to leading performance metrics on its newest products, and although 3dfx arguably has the best brand among PC gamers and it does have the largest market share of 3D chips, many Fools are increasingly citing competitors as giving 3dfx a run for the money, if not beating it on many measures.

An often praised competitor is NVIDIA, a company that made headway in 3dfx's market this year with its hot RIVA graphics chips. NVIDIA was ranked the most influential PC graphics company by PC Magazine this fall, and in the wake of several large deals with the likes of Compaq, IBM, Micron, and Hewlett-Packard, NVIDIA has indeed grabbed more headlines and attention (and more praise) than 3dfx the past year. We disagree on some levels, but NVIDIA is probably now seen by many people as the current top dog in gaming 3D graphics.

2) A sustainable advantage gained through business momentum, patents, visionary leadership, and/or inept competition.

3dfx can't lay claim to any of the qualities listed above with too much conviction. The company does have momentum in that it churns out new generations of its Voodoo product regularly, but its competition has product momentum, too (perhaps more so). 3dfx's management claimed to be visionary in its purchase of STB Systems (saying that integration of design and manufacture was where it's all going), but the vision has yet to play out favorably by the numbers. The company has patents, but so does NVIDIA. Finally, no, 3dfx doesn't have inept competition. It competes with viable alternatives to its products.

The main advantage that we once felt 3dfx possessed was its branding and its tight relationship with game makers. You still see the 3dfx Voodoo logo on a great deal of PC game boxes in the store. You also see the NVIDIA logo, though. Essentially, gaming software makers want to cater to the largest possible market, so they try to make their software highly compatible with any quality 3D graphics accelerator. While 3dfx's branding is still to be commended, it doesn't have a lock on the consumer.

3) Excellent past share appreciation measured by a relative strength of 90 or higher.

This stock has a relative strength of 35, meaning that it has underperformed 65% of the market the past year. The stock had doubled from its 1997 IPO before we bought it, and then soared another 50% in the months following our purchase, but it has been downhill since.

4) Good management and smart backing.

In October 1999, CEO Greg Ballard resigned and was replaced by longtime semiconductor industry executive Alex Leupp. Although Mr. Leupp has much experience, it is too early to see where he can lead 3dfx. Mr. Leupp has an experienced older management around him, and the experienced management team from STB Systems, too, but working together is still a new experience.

Overall, 3dfx is a young company (founded in 1994), and presumably many of its 250 employees are young. (Not that that's bad! The Fool was founded in 1994 and has about 230 employees, most under the country's median age.)

5) The greater the consumer brand, the better.

With PC gamers, 3dfx does have a good brand name. One slight possible problem, however: just as gamers always want new games (the latest and the greatest), they're also very "fashion" conscious (or "technology aware") when it comes to, well, technology. Many gamers see Voodoo as "out" right now, and prefer NVIDIA.

Kids. So fickle.

6) A significant constituent of the financial media is recently on record for calling it overvalued.

Not a whit. The stock hasn't garnered any such attention and it has, on a price-to-book value basis, actually looked inexpensive. Not inexpensive in a way that we'd want to buy it (or keep it), but not "overvalued" either. We think that we've found something better, though, so whatever price 3dfx fetches, we want to move our money to, hopefully, our new and better investment.

Closing Time

After ATC Communications, 3dfx is the BreakerPort's second-worst investment in the past 5 1/2 years, losing over 60% in just under two years. This certainly goes to remind everyone that our judgment is far from perfect. If it were perfect, we wouldn't be human. Success is largely about being "right" two times out of five. When you are right, you are rewarded for a long time. When you're wrong, you're essentially harmed just once. We've been harmed by this stock, but only once. It shrunk to such a size that it's really not of much consequence or importance to the Rule Breaker Port anymore.

One key lesson to take away from our loss regards the "industry." The computer chip industry was never a favorite of ours. It is "commodity" like, typically lower margin, and is highly competitive and products have a very short life span. We looked beyond these facts because this company seemed so interesting and hip. In the end, even the greatest companies are locked into the industries in which they operate. If an excellent company operates in an average investment-quality industry, the company will, in the end, typically be only an average quality investment -- or less.

We wish 3dfx all the best of luck, and almost surely we'll keep using its products when we play games. We just won't be part owners in the business. Fool on!