Aftermath unclear from S3-Diamond merger

While investors looked askance at graphics chip maker S3 Inc.'s intention to acquire multimedia hardware maker Diamond Multimedia Systems Inc., the deal is being applauded by some analysts.

The proposed deal, a stock swap worth $175m (£107m), 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 and Diamond's 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." 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.

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, California, 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.

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.''

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