Between an X-Box and a Hard Place: Nvidia's Stock Slips 24% After Big Run

The chipmaker for Microsoft's planned X-Box game console is finding a road paved with ifs.
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SAN FRANCISCO -- Graphics-chip maker

Nvidia

(NVDA) - Get Report

finally fell Tuesday, at least for now ending an extraordinary rise that began March 6 with the news that

Microsoft

(MSFT) - Get Report

would use Nvidia's chip in its

X-Box

game console.

And Tuesday's 24% drop to 114 is just the beginning, say two short-sellers. Other graphics-chip companies have risen sharply in the past, only to fall in this historically volatile sector.

Nvidia will prove to be no different, these short-sellers say, because its path to X-Box fortunes depends on a number of big ifs: if Nvidia can produce the chip for the X-Box on time; if Microsoft can make the X-Box on time; if the X-Box can steal customers away from the already popular

Sony

(SNE) - Get Report

PlayStation2; and if Nvidia can produce and sell the X-Box chip for a significant profit.

Nvidia executives are out to prove the naysayers wrong, and analysts who follow Nvidia insist that the 7-year-old company and its charismatic CEO Jen-Hsun Huang will reap considerable profits from the X-Box. Nvidia CFO Chris Hoge says the days of volatility in the graphics market are over. "The rules and valuations of the past 10 years don't apply," says Hoge.

The rise in Nvidia's shares was unprecedented in the graphics business. From March 6, when the news broke that the company had muscled tiny chip start-up

Gigapixel

out of the X-Box, through March 13, the stock rose 159% to an all-time high of 150, boosted in part by a prediction from

Prudential Securities

analyst Hans Mosesmann that the stock would rise to 180 within a year and another by

Morgan Stanley Dean Witter

analyst Mark Edelstone that it would hit 200. (Both firms were underwriters of Nvidia's Jan. 22, 1999

IPO.)

But Mark Cohodes, a portfolio manager for short-seller

Rocker Partners

, says a lot can happen in the two years between now and when the X-Box is supposed to sell in large volume. "The X-Box is hype," he says. "We don't know whose technology will be on top then. Two years ago, it was a race between

3D Labs

(TDDDF)

,

3Dfx Interactive

(TDFX)

,

S3

(SIII)

and

Cirrus Logic

(CRUS) - Get Report

."

3D Labs, for instance, has fallen from a high of 50 in September 1997 to 7 3/16 Tuesday. S3 has since diversified away from the graphics-chip business.

The graphics-chip business is tough because it has the shortest design cycles in the chip industry. Graphics-chip companies race to stay ahead of their competitors, and those that slip find themselves punished by loss of sales and falling stock prices. Nvidia will be hard-pressed to produce the advanced NV25 chip for the X-Box -- promised to have 10 times the performance of the best chip now on the market -- out by late 2001 when the X-box is supposed to launch, says chip analyst Peter Glaskowsky of research firm

MicroDesign Resources

. (His firm has no consulting relationship with the company.)

A slip-up could give a competitor the ability to slip into the box instead. Indeed, one person at Gigapixel, who spoke on condition of anonymity, says his company is ready to step back in.

Microsoft is still working with Gigapixel on advanced graphics chips for the PC platform, he says. Microsoft owns a 10% stake in the company. Microsoft x-ed Gigapixel out at the last minute only because it got nervous that the start-up had no track record of getting chips out on time, this person says.

Edelstone at Morgan Stanley predicts the X-Box will result in $2 billion worth of sales for Nvidia over five years. Because Nvidia says the chips will sell for around $50 each, Microsoft, a new player in the market, will have to sell 40 million boxes.

In comparison, Sony sold 50 million original PlayStations in the five years it was on the market. Cohodes of Rocker Partners is skeptical that sales will be that high, because by the time the X-Box ships, there's a strong likelihood the Sony PlayStation2 will be solidly established.

Profits also could prove slimmer than expected. Nvidia CFO Hoge says the company expects a gross margin in the area of 20% per chip, but others in the graphics industry are skeptical.

One executive at a competing company, who spoke on condition of anonymity, says gaming consoles are typically sold below cost at $400 each retail, and the manufacturers put intense pressure on component makers to keep prices down. Therefore, margins are slim. "The chip will have to be very close to cost," the executive says.

Add that to Nvidia's game of ifs.