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Technology Stocks : 3DFX -- Ignore unavailable to you. Want to Upgrade?

To: Sun Tzu who wrote (8733)	11/2/1998 5:39:00 PM
From: Michael G. Potter	Respond to of 16960

Warning - this is quite long, I had time to do some typing while on a flight to and from Hartford. Sometimes I wish I was a technical trader - there's much less thinking involved. Since I base my investment decisions on fundamental analysis, I thought that I should reconsider my investment in 3dfx to take into account Creative Labs buying 6% of the company and some recent news in the industry. I'm starting to see the light at the end of the tunnel for the Annual Operating Plan season at my job, so I'll be able to finish my financial number crunching at call 3dfx sometime soon. My investment thesis is that 3dfx currently has the potential to be a if not the leading supplier of videocards to the personal computer market. This opportunity has opened up because of their early and industry leading investment in 3d graphics for consumers. Their early work concentrated on performance in games (and they had an early focus on arcade games). For two years they ruled the 3d world via their Voodoo and Voodoo2 chipsets. Their margins were so good and the market saw the benefit of 3d acceleration as very high that they attracted serious competition. In my mind, ATI, nVidia, and S3 represent their competition with Permidia and Rendition also in the wings. The market is large and growing larger with $3 billion available in the near term. 3dfx is strong with over $90M in cash. They're investing a significant amout in R&D every quarter. Note that 3dfx is a technology company and they came out of nowhere to gain a significant market share. This could just as easily happen to them in the future. Their branding and the relationships they're building with OEM's might protect them for a while, but the best technology will win out in the long run and their high margin gamers business is focussed almost exclusively on performance. In the past, 3dfx was a retail upgrade company which is very cyclical. Brand and consumer awareness is important as is maintaining a technology lead. OEM companies can balance performance with cost. My 3dfx model has them gaining a significant presence in the OEM market while still producing high-end retail chips (these also could go on very high-end OEM machines). I would not want to invest in a company directly competing with Microsoft or with Intel. Much has been made about Glide, but the fact is that when the Voodoo chipset first came out, DirectX did not support 3d acceleration very well (at all, actually) and it was a Windows solution, not a DOS solution. To make available the full power of their chipset, 3dfx had to develop an API with related drivers. 3dfx has always provided DirectX drivers and devotes a great deal of effort to those drivers. They also have supported OpenGL for quite a long time via their miniGL drivers. They've taken some grief about the fact that they still do not have a full OpenGL ICD, but they were a games company and their gaming solution is still the superior gaming OpenGL implementation. Glide provides a performance boost and a differentiator for them plus a route to add features to their cards that can be quickly taken advantage of. It is not competition to Microsoft. Intel is the other bogeyman. There is a great deal of fear associated with Intel coming into the graphics market. Note that Intel was an early investor in 3dfx (as it has been in other companies). They also developed their own graphics chipset (in conjunction with a partner). Why did they do this? Intel wants to create demand for faster and better processors. They make the highest profit margin on their high-end. Right now, the only applications that require their high-end processors are multi-media applications. Even with accelerators, faster cpus help. They also are promoting their AGP standard and the i740 helped there (and it is a decent low cost chip). They're investing in companies that are striving to increase bandwidth availability to the average consumer so that there will be a requirement for higher-end processors (older Pentiums handle web-surfing without any difficulty). Where 3dfx's products reduce the need for higher-end products, Intel will not be happy. Intel will be releasing chips with the KNI instruction set in the near future. The newer chips will be able to process polygons much faster and pass the information on to the graphics system much faster. 3dfx may be working on geometry acceleration for their next retail part. If Intel were to build anything into their processors, geometry acceleration would be a likely candidate. However, 3dfx's product would do well in the upgrade market for Pentium II's that did not have the KNI or other acceleration built in. Intel has recently invested in Evans and Sutherland, a high-end graphics card maker. Remember, Intel will be releasing Merced in 2000. They have a vested interest in the high-end workstation market where cards that E&S make are key. There also may be plans to release the 'Whittany" chipset for motherboards that will include an i740. That seems to be aimed at AMD as it allows Intel to more effectively offer lowcost solutions. It will hurt ATI more than 3dfx as ATI gets a fair amount of sales from chips mounted on the motherboard. The i740 is far enough behind 3dfx's Voodoo2 that Intel's plans here may help 3dfx's more lucrative retail upgrade market. I then look at the stock price and the balance sheet. I basically try and decide what a reasonable P/E ratio should be. Even though 3dfx's growth rate is very rapid right now, it is very risky and cyclical. To me, than means less than market P/E (I'm somewhat of a value investor). Their balance sheet is fairly clean. Inventory is somewhat high and receivables are high as well, but they have tons of cash. Not shown as an asset is their patents and they hold several that may be key in the future. The total market they could serve also is pretty high once you look past the gamer market. So there's plenty of room to grow, they have good technology (with indications that they'll maintain their edge), and they have decent brand recognition. From a base of $15ish, there's a good chance of $30 - $50 in a few years if they can carry out their game plan and their cash mitigates some of the downside risk). That was my story and then two things changed. Voodoo2 ran out of steam a little earlier than I thought (bad Q3 results) and Creative Labs bought in big time (6% of shares). The poor Q3 results confirmed my suspicion that the retail market is too volatile to be depended upon for 100% of 3dfx's sales. The real bad news was how much of a surprise it was to 3dfx and how much Diamond had cut back on purchasing. Then Diamond and STB announced that they had lent nVidia $3 million each to help with the launch of the TNT. The stock dropped to $8 on the announcement and then slowly went back up to $9 - $10. The reason for the recovery / floor at $8 then came out. Creative Labs had been a heavy buyer of shares and now owns 6% of 3dfx. Why would CL buy the shares and what will it mean for 3dfx's stock price? From their SEC filing, CL says they're buying 3dfx stock as an investment. It is possible that CL sees a big chance to make a large profit on undervalued 3dfx. If so, what makes them think that 3dfx is so undervalued? First, CL won the Gateway OEM contract for Banshee. Second, CL probably has a decent idea of 3dfx's future roadmap. Third, CL knows a fair amount about nVidia's performance and their ability to compete with 3dfx. All of these reasons are very bullish for 3dfx. CL may be attempting a takeover of 3dfx. If that were the case, they would have to pull off a friendly deal as 3dfx's main asset is their engineers. If the takeover were hostile, then many of the engineers would leave. A takeover makes sense if you believe that CL wants to expand out of the soundcard area into graphics. They've already started down that path by producing videocards using other people's chipsets. CL knows very well how much owning a market segment can contribute to profitability. Their soundcards have only recently been challenged by other chipsets and this has allowed them to amass a large warchest. If they were to do a takeover, then a "fair" takeover price needs to be determined. I doubt that any price would be over $20 / share which is a significant premium to the current value. I know that 3dfx has been higher than $20 in the not too distant past, but that's not how takeover prices are established. CL and 3dfx together would be a formidable retail and OEM force. CL may simply be blocking Diamond. Diamond is the largest supporter of the key competition to CL's soundcard franchise. 3dfx-powered video cards have provided most of Diamonds profit's over the last while. 3dfx's chipsets are often in very short supply when they're first released. CL may be trying to move to the front of the line and too make Diamond think twice about buying chips from 3dfx as it will boost the value of CL as CL owns so many 3dfx shares. This would apply to STB and the other board makers. Why buy from 3dfx or at least why be strong supporters when it will help CL? A fairly cheap investment for CL to strike at their competition. My conclusion is to read the CL purchase as a bullish signal and continue to hold onto my shares. Two of the three options are bullish for the short-term. The CL action may cap the long-term appreciation potential of 3dfx, but shouldn't have that much effect over the next two quarters. Michael Ps - I'll sell if I think there's a major, negative change in my thinking.