Aftermath unclear from S3-Diamond merger

The propose deal, a stock swap worth $175 million, would continue the consolidation in the graphics industry that started with the merger of graphics chip maker 3dfx Interactive Inc. and board maker STB Systems Inc. earlier this year.

Both S3's (Nasdaq:SIII) and Diamond's (Nasdaq:DIMD) stocks reeled after the news was made public Tuesday morning. But some analysts applauded.

"This could definitely work," said Mike Feibus, principal analyst at semiconductor watcher Mercury Research Inc., listing the possible strengths each company brings to the deal: "S3 is going down the path of integration and Diamond has already diversified it products."

More efficient
S3's chief technology officer, Andrew Wolfe, said the deal would help S3 redefine its graphics business and rout out inefficiencies in the market.

"The previous model added a lot of cost," he said. "We had to develop products, make reference boards, and then sell Diamond and Creative on the product, followed by training them how to use it." Now, several steps can be bypassed, speeding products to market and reducing costs.

In addition, the move will give S3 ideas for new markets to develop, he said. "This gives us a chance to diversify."

That means a second chance for the struggling chip maker. Three years ago, S3 attempted to diversify its semiconductor products. The net result: S3 missed a critical cycle of sales in the graphics market, because the company's attention was elsewhere.

This time the company believes that it can get it right.

"We can get more products to market with the same number of employees," said Wolfe, hinting that layoffs would not be part of the merger. In addition, Diamond's focus on other markets such as home networking and its Rio MP3 player will give S3 an initial path to follow.

Investors are not so confident, however. Shares of S3 closed down 69 cents at $8.75 and Diamond finished 94 cents lower at $4.75 in active trading, both on the Nasdaq stock market.

Investors were slightly negative on S3 rival NVidia Corp.'s future as well. The graphics chip maker's stock price fell slightly on the news of the merger.

More mergers could be coming
The S3-Diamond merger comes after 3dfx Interactive Inc. merged with board maker STB Systems Inc. earlier this year. The two mergers leave multimedia hardware maker Creative Labs Inc. and Nvidia, the odd men out. Nvidia has only one of the three main retail players -- Creative -- to sell its chips to, while Creative only has a single source for chips.

Mercury's Feibus said a merger between the two companies could not be ruled out, but was by no means a certainty. "Being an independent board maker and independent chip maker is not as attractive as it use to be," he said. "But this isn't dire for Nvidia."

Nvidia has put on a confident face as well. "Mergers like this that make little sense happen because the companies have no strategy," said Mike Hara, director of strategic marketing for Nvidia. Yet, he admitted that "Diamond is a big seller of TNT (graphics chips from Nvidia) -- that business will eventually go away."

S3, based in Santa Clara, Calif., said the move represents a major strategic shift to enter the Internet appliance and home networking markets. But the move is also further consolidation between graphics chip firms and board makers.

Looking for diversification
Diamond, most recently known for its Rio Internet music player, also develops home networking products and is the biggest maker of graphics accelerator boards, which are used for two- and three-dimensional graphics in personal computers.

S3's graphics chips, the Savage family, are bundled onto these graphics boards and others, and sold either at retail as an add-in card or to PC makers directly.

``S3 has two clear objectives,'' Ken Potashner, president and chief executive told analysts on a conference call. ``First is an aggressive return to profitability and second is a diversification of our technology base.''

Comparing Diamond and S3
San Jose, Calif.-based Diamond is almost three times bigger than S3. It reported $608.6 million in revenues in 1998, with about 70 percent of its revenues typically coming from graphics boards, its chief executive William Schroeder said.

S3 had $224.6 million in fiscal 1998 revenues, with a net loss for the year of $113.2 million, including restructuring charges. S3, which had been struggling since it missed a major product cycle, has been rebounding with its new Savage line.

``They are probably both in a recovery mode,'' said Dan Scovel, an analyst with Fahnestock & Co. ``It could be an interesting deal here.'' Scovel continues to rate S3 a buy.

Under an agreement between the companies, Diamond shareholders will receive 0.52 of a share of S3 for each share of Diamond Multimedia.

The companies said they plan to integrate their chip and board business, a move analysts said is likely to alienate other board companies who may not wish to continue buying S3 graphics chips. But in some cases, PC makers who are adding the boards themselves will determine which graphics chips to use.

Rio a separate business
Diamond's Rio Player business, however, will remain a separate business, with the potential for an eventual spin-off. ''The Rioport strategy, as it evolves, we will position that as a spin out, as a primary intent,'' Schroeder told analysts, referring to the company's music portal called Rioport.com

Diamond executives also said they plan to introduce a new version of the Rio player at a press conference in Los Angeles Wednesday night, along with some strategic announcements.

The Rio is a pager-sized device that can store CD-quality songs encoded in the MP3 downloading format. Just last week, Diamond won a major legal battle, when a U.S. Circuit Court of Appeals ruled that the Rio MP300 device did not qualify as a digital recording device and did not violate anti-piracy laws.

S3 will have cash to invest in future growth of these businesses, plus Diamond's foray into home networking. S3 said that it is scheduled to receive 252 million shares of United Microelectronics Corp. stock, which is valued at approximately $600 million, through a joint venture. S3's current cash position is about $130 million.

The deal is expected to close in October. Potashner will remain chairman and chief executive of the combined companies, while Schroeder, president and chief executive of Diamond, will become president and chief operating officer.

Reuters contributed to this story