Really interesting article from Smartmoney.com...S3 Sheds Its Cocoon
By Monica Rivituso
HOPING TO TAKE WING
Source: DJNR
AH, SPRING...the time of year when new leaves bud from trees, flowers poke out of the hard ground ? and, just like caterpillars emerging from their crusty cocoons, businesses shed their core operations and emerge newly refocused and ready to take flight.
That's pretty much what chipmaker S3 (SIII) did today when it announced that it would jettison its core PC graphics-chip business and shift its focus to Internet appliances (a prospect we alerted our readers to three weeks ago). It's too early to tell whether S3 will really emerge as a vibrant butterfly ? but at least the metamorphosis makes it less likely that the company will get squooshed.
"The graphics-chip business is very competitive and [the fact that] they're getting out of it is very positive," says Robertson Stephens analyst Arnab Chanda.
S3 will transfer its graphics-chip operations to a new joint venture it's forming with Via Technologies, a Taiwan-based chipmaker, for $323 million in cash and stock. But the deal seems to offer a little more on second look. First, half of that $323 million will come from S3 stock that Via (a large S3 shareholder) will return. So, the deal has the appeal of a stock buyback. In addition, S3 will sell Via 3 million additional shares priced at about $18 apiece. S3 will also receive additional "earn-outs" if the joint venture meets certain financial milestones. CEO Ken Potashner says this could add another $200 million, bringing the deal's total value to $600 million. The transaction is expected to close by July of this year.
"We were looking to create a separation [for our graphics-chip business] and this is the vehicle," says Potashner. (Of course, given the Nasdaq's rout yet again Tuesday, no one really seemed to notice S3's news. The stock ended the day about 5% lower, along with the bulk of other tech stocks.)
Wall Street has been mulling over deal possibilities ever since Potashner said quite clearly in the fourth-quarter report that S3's networking and Internet-appliance businesses were undervalued and that shareholders would be better served if the graphics-chip operation was separated. Via was the odds-on favorite to land the graphics-chip operations, since it already had a joint venture with S3, not to mention that $145 million, 14.9% stake in the company.
S3 chose to put the chip operations into a joint venture rather than sell them outright because it wanted to retain a key agreement with Intel (INTC). S3 has royalty-free access to Intel's P6 bus. To put it simply, Intel's P6 bus ? essentially the wires that run between various chips ? is the only game in town. While Via has access to S3's intellectual property, it did not get ownership of S3's Intel agreement. Why is this important? If the PC platform makes its way into Internet appliances, those rights to Intel's bus could come in handy for S3. "I just simply didn't want to let that go," Potashner says.
Now, S3 is relaunching as an Internet-appliance company, focusing on home-networking products, digital-audio players and high-speed modems that will help build the digital home. Although S3 already has Internet-appliance products, the company's foray into this area is relatively new. Its traditional graphics chips account for two to three times the sales of its newer Internet-appliance products. But those newer offerings are where the growth opportunity is. Home-networking sales will likely increase in the high double or even triple digits for the next couple of years, says Chanda.
The foundations for S3's business shift were laid when it purchased Diamond Multimedia Systems last September for $166 million in stock. Diamond, as it turned out, was a key piece for S3. With the acquisition came digital and analog modems, the popular Rio digital-audio player (which enjoys an 80% market share, according to Potashner) and the HomeFree line of networking products. Now, S3's goal is to build on these strengths and broaden its offerings.
"If they can take the success that they've had with the Rio player and work into a solid position with new markets," says Dataquest senior analyst George Iwanyc, "[S3's new focus] could do really well for them."
A new focus is arguably needed. S3, once a leader in the graphics-chip industry, missed a key product transition a couple of years ago and ended up losing most of its customers. S3's stock hit a low of $2 in October of 1998, roughly 88% below where it was a year earlier. Not that this was all that unusual. In this industry, leaders are crowned and dethroned with rare ferocity, thanks to intense competition and rapid product development. When Potashner, known as something of a corporate-turnaround artist, came on board about a year and a half ago, the goal was to breathe some health back into S3's sickly graphics-chip business. After that, the company set its sights on Internet appliances.
S3's transformation will likely benefit the stock. But again, the company will still have to prove to the Street that the new focus will pay off. If fourth-quarter results are any indication, there's some promise here. Internet-related businesses increased revenue 46% sequentially, with the Rio business alone increasing sales 76%. And Rio sales continue to be robust, Potashner says.
S3 also has a strong balance sheet on its side, bolstered by a 41% stake in RioPort.com (a digital music portal that will likely go public this year) and a stake in Taiwanese chip-foundry United Microelectronics valued at $1 billion. Given the strength of its assets and high-growth markets, Robbie Stephens' Chanda says S3 stock should be valued at about twice its current level in the high teens. All the same, he's sticking with his $25 price target until the company shows further proof.
But Potashner seems confident in S3's new focus, regardless of how tech stocks are viewed these days. "We feel we're doing the right things. Now," he says, "we just need the Nasdaq to turn around and people to notice." |
