Neowin.net

One of the more interesting takeaways from Nvidia's upbeat analyst meeting yesterday is the possibility that the company will not pursue a "design win" for the second generation of Microsoft's Xbox videogame console.

Nvidia makes specialized graphics chips for Microsoft's Xbox, which hit the market in the fall of 2001. It was a high-profile customer win for Nvidia, whose main business is general-purpose graphics chips for PCs, but it has not been without problems.

Last spring, Nvidia and Microsoft got tangled in pricing arbitration when Microsoft, in an effort to cut costs on the moneylosing Xbox, wanted to pay less for the chips. In February, an arbitration panel sided with Nvidia, which had locked up pricing when the companies signed their original deal.

Analysts estimate that Nvidia's gross margins are about 25% on Xbox chips, compared with 30% to 35% for overall company margins.

There has been spotty demand for Xbox as Microsoft struggles to get game developers to write programs exclusively for its console. One of the most highly anticipated Xbox games--Halo 2, developed by Microsoft's game division--will miss the crucial holiday selling season. That may crimp sales of Xbox and, subsequently, Nvidia's chips, because sales of game consoles are driven by availability of games.

"Add these things up and it's a bad business for Nvidia," says Michael McConnell, analyst of Pacific Crest Securities, who believes that Nvidia should not and will not pursue a deal to make chips for Xbox 2, due in 2005 or 2006.

News source: Forbes - Will Nvidia, Microsoft Split On Xbox 2?

Whether Nvidia and Microsoft work together again will depend on the terms, says Brian Alger of Pacific Growth Equities. "Microsoft doesn't want to pay that much [for the chips]. One has to assume [it] will be more careful."

Indeed, the company is not without options. Microsoft could structure a deal similar to the one Nintendo has with its graphics chip developer, ATI Technologies. Nintendo does not buy its chips from ATI. Rather, ATI developed the chip, for which Nintendo owns the rights and is responsible for manufacturing. ATI is then paid a royalty on every GameCube and every software title.

Xbox-related revenue accounts for about 10% of Nvidia's sales, which totaled $2 billion in fiscal 2003, ended in January. Company spokesman Derek Perez says Nvidia does not have an agreement to produce chips for Xbox 2 (one could conceivably be forthcoming), but that "Microsoft is still a great partner and this is still a good business."

Nvidia did not update first-quarter guidance at its meeting, but analysts nonetheless came away bullish. Morgan Stanley says Nvidia "articulated a well-thought-out corporate strategy covering product roadmap, marketing and manufacturing. This confirms our view that Nvidia is positioned once again to enjoy a reacceleration of revenue growth, margin expansion and a significant increase in earnings power."

Pacific Growth Equities says the company "should be able to do better than consensus EPS of 10 cents and should have little trouble meeting our 12-cent estimate."

Alger says that one of the reasons Nvidia did not update its guidance is because Xbox sales will be slow until this May, when a widely anticipated price cut on all videogame consoles takes place.