3Dfx Bear's Rebuttal
Jeff Fischer (TMF Jeff)

Fools always try to present a balanced argument, and I admitted that 3Dfx has a great product and a strong business niche with high-end users. Louis presented the Bull side while mentioning some of the negatives, but he mainly brushed over them. Even so, some of his arguments prove my points, and some are incorrect.

First, you can't value a semiconductor stock using the PEG or the YPEG measure. So, the given PEG of 0.39 is meaningless, as is the YPEG that suggests a $30 fair value for the stock. Overall, the valuations granted this usually low-margin and competitive industry have not been generous except during short bursts of excitement. Remember when S3 <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SIII)") else Response.Write("(Nasdaq: SIII)") end if %> and Trident Microsystems <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TRID)") else Response.Write("(Nasdaq: TRID)") end if %> were hot players in similar niches? Both stocks soared and had valuations similar to 3Dfx's current valuation. Now both stocks trade at less than 0.7 times sales, about 1 times book value, and 10 times and 15 times earnings.

3Dfx's expected revenue growth, if accurate, supports my fear that the company's market is limited to high-end users who are willing to spend the extra money. For most people, Intel's convenient 3D technology will be more than adequate. UBS Securities expects 3Dfx to have 1998 revenue of $149 million and 1999 revenue of $188 million. That's 26% revenue growth year-over-year. Not incredible. Intel, a $150 billion company, grew sales 20.3% in 1997. Meanwhile, 3Dfx's earnings growth should be about 32% in 1999. Intel achieved 35% earnings per share growth in 1997. You might as well buy Intel, a world leader with a stock that trades at a lower multiple to earnings and with much less risk.

At $24, 3Dfx trades at 27 times Louis's projected diluted earnings per share of $0.89 for this year. If 3Dfx can grow earnings 32% in 1999 as anticipated, the stock currently trades at 20 times 1999's possible $1.18 in earnings per share. Even when Intel grew earnings 35% in 1997 the stock traded at 17 to 20 times earnings, on average.

This industry almost always trades at a discount to its earnings growth rate, so 3Dfx looks about fairly valued right now. If you want to buy the stock you've almost got to hope that the current earnings estimates are low. That's what the Fool did and we were right. Earnings estimates more than doubled less than six weeks after the Fool Port bought this stock. Yet, the stock didn't react. The valuation was already generous and had apparently already built in the good news.

3Dfx has superior products (and the pipeline) and it dominates a certain gaming niche, but it is a semiconductor chip company (without its own manufacturing), and it mainly serves the high-end gaming industry -- not the largest industry in the world, and not one without tremendous risk. With the recent events (Intel jumping in) and the inability of the stock to react to positive earnings news, I don't think that the risk-to-reward ratio is proving worthwhile.

The story is out. The big earnings surprise is out. The stock is lingering. The investment situation has changed since the Fool Port first began to look at 3Dfx in the $16 to $18 range. The stock was then valued 60% to 42% below the price that we ended up having to buy it, unfortunately. Perhaps our market-beating return in the shares already happened -- without us.

Of course, I hope I'm wrong. Either way, 1998 promises to be a record year for 3Dfx, and I have well-researched expectations and I'll be watching the quarterly reports closely. A recent Electronic Engineering Times issue that stated that Intel's 3D is as good as or slightly better than the competitions' has me even more concerned, though.

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