It didn't take long for graphics chipset vendor S3 Inc. (Nasdaq: SIII) to find uses for its treasure chest.
The plan to buy board maker Diamond Multimedia Inc. (Nasdaq: DIMD) calls for issuing almost 18.4 million S3 shares, worth about $173.3 million before regular trading opened today. Considering Diamond closed yesterday with a market capitalization of $185.3 million, it's easy to see why Diamond shareholders aren't terribly happy about the deal.
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More difficult to understand is the pessimism of S3 investors. S3 wasn't going to just sit on the $600 million in stock it got last week. When a real company suddenly finds itself with a stake worth more than the value of its entire operations, it does one of two things: spends it on something; or turns into Berkshire Hathaway. There's only room in the world for one Warren Buffett, so S3 shopped around.
A would-be consolidator in the 3D graphics industry doesn't have many alternatives. None of the chipset makers are interested in merging, especially not with S3, whose technology is seen as lagging. ("We have award winning graphics," says Dan Bivoli, nVidia's vice-president of marketing and Potshots at Competitors. "S3 is even further from award winning graphics than 3dfx is.")
That leaves companies who make boards that use 3D accelerator chips. The acquisition of STB essentially left two well-known brands, Creative Technology Ltd. (Nasdaq: CREAF) and Diamond. The latter features messier financials, but also a broader product line. Even Diamond's cracks ultimately helped S3, because they let the latter negotiate a price-to-potential-value ratio roughly equivalent to what the Dutch paid for Manhattan.
Critics of the deal forget that S3 certainly hasn't done well in recent years with its current business model. The company has lost money for five straight quarters, and is expected to lose money in the current and next ones as well, according to First Call.
Even companies who have set previous merger examples -- namely 3dfx buying STB -- seem puzzled by S3's choice. "I find the positioning of the deal a little odd," says Michael Howse, senior vice-president with 3dfx. "S3 has traditionally been very focused on one business, graphics, and they're getting married to a company that hasn't been that successful in that marketplace."
S3 must learn how to juggle more complex inventory problems, Mercury Research analyst Dean McCarron notes. It also has to face lower gross margins, because board makers operate on thinner profits than chipset vendors.
Despite the many questions that rightfully surround today's announcement, this is best alternative S3 had. Beyond the potential benefits to S3's core business, Diamond offers the prospect of expanding into other fields, such as digital audio and home networking products. Skeptics such as 3dfx's Howse see that as a negative, because S3 has no experience operating in those areas; but that's why S3 is buying Diamond in the first place, to get that expertise. And those non-graphics businesses are profitable, Diamond says.
So cheer up S3 shareholders. You're getting a Diamond, albeit a deeply marred one, for the price of glass.
According to nVidia, 90 percent of its sales come from OEMs, an area in which Diamond is practically non-existent. And in the retail channel, Diamond's Viper V770 sells less than the Creative Blaster, both of which use TNT2 sets. nVidia dimisses today's announcement as less of an issue than 3dfx's purchase of STB. "And that wasn't an issue at all," nVidia's Bivoli says.
Mercury's McCarron suggests that nVidia may take a look at buying Creative at some point, but again, why bother if they're the only ones left anyway? In fact, S3 may try to buy nVidia itself, McCarron says. "That's the rumor that was going around six months ago," he notes.
Not likely. "We've been approached by just about everybody, and have chosen not to do anything," Bivoli says. "We feel no need to do it. We have a business model that's proven to be very successful."
nVidia and 3dfx compete at the market's high-end, where 3D performance matters most, 3dfx's Howse says. "If anything, I think this decreases competition, because it indicates to us that S3 is moving away from the graphics marketplace," says Howse, noting that the press release announcing the S3-Diamond deal doesn't even mention graphics, although it still comprises all of S3's business and 60 percent of Diamond's.
Add that to the fact that 3dfx has finally started scoring some OEM wins -- Howse mentions Dell and Gateway -- and 3dfx looks better all the time.
The overall technology market remained slightly lower in afternoon trading. The Nasdaq Composite Index was down 3.54 to 2626.74, the S&P 500 had slid 2.69 to 1346.31, and the Dow Jones Industrial Average had fallen 37.04 to 10778.94. 22GO>