NVIDIA Corporation Q1 2007 Earnings Conference Call Transcript (NVDA)

May.11.06 | About: Nvidia Corporation (NVDA)

NVIDIA Corporation (NASDAQ:NVDA)

Q1 2007 Earnings Conference Call

May 11, 2006, 5:00 p.m. EST

Executives

Michael W. Hara - Vice President, Investor Relations

Jen-Hsun Huang - President and Chief Executive Officer

Marv Burkett - Chief Financial Officer

Analysts

Tayyib Shah - Longbow Research

Randy Abrams - Credit Suisse First Boston

Mark Edelstone - Morgan Stanley

Hun Lee - Global Crown Capital

Jason Pflaum - Thomas Weisel Partners

Nicholas Aberle - Caris & Company

Quinn Bolton - Needham Incorporated

Pranay Laharia - Deutsche Bank

Dan Morris - CIBC World Markets

Krishna Shankar - JMP Securities

Simona Jankowski - Goldman Sachs

Operator

Good afternoon and thank you for holding. I would now like to turn the call over to Mr. Michael Hara, NVIDIA’s Vice President of Investor Relations. Thank you. Sir, you may begin your conference.

Michael W. Hara

Thank you. Good afternoon and welcome to NVIDIA’s conference call for the first, fiscal quarter ended April 30, 2006. On the call today for NVIDIA are Jen-Hsun Huang, NVIDIA’s President and Chief Executive Officer; and Marv Burkett, NVIDIA’s Chief Financial Officer.

Before we begin today’s call, I would like to take care of some general administrative items. Your lines have been placed on a listen-only mode until the question and answer segment of today’s call. During this call, we will discuss some non-GAAP measures about net income, net income per share and gross margins and other line items from our consolidated statements of income when talking about our results. You can find the full reconciliation of these measures to GAAP in our financial release which is posted on the investor relations page of our website at www.nvidia.com. This call is being recorded. If you have any objections, you may disconnect at this time.

Please be aware that if you decide to ask a question, it will be included in both our live transmission, as well as any future use of the recording. Also, shareholders can listen to a live webcast of today’s call and view our financial release at the NVIDIA Investor Relations website. The webcast will be available for replay until the company’s conference call to discuss its financial results for the second quarter of fiscal 2007. This conference call is the property of NVIDIA. Any redistribution, retransmission or rebroadcast of this call or any portion of it, without the express written consent of NVIDIA is strictly prohibited, and may result in civil and criminal penalties.

During the course of this conference call, we may make forward-looking statements based on current expectations. Forward-looking statements, including statements as to our second quarter 2007 outlook, growth, growth drivers, market share, investments, competitive position, design wins, customer demand, new and forthcoming products and products and technologies pertain future events and are subject to a number of significant risks and uncertainties. The company’s actual results may differ materially from results discussed in any forward-looking statements. For a complete discussion of factors that could affect the company’s future financial results and business, please refer to the company’s Form 10-K and annual report for the fiscal year ended January 29, 2006, quarterly reports on Form 10-Q, and the reports on Form 8-K filed with the Securities and Exchange Commission. All forward-looking statements are made as of the date hereof based on information available to us today and the company assumes no obligation to update any such statements. The content of the webcast contains time-sensitive information that is accurate only as of May 11, 2006.

Consistent with the requirements under Regulation FD, we will be providing public guidance directly in the conference call and will be unable to provide significantly more information in offline conversations or during the quarter. Therefore, questions around our financial expectations should be asked during this call. At the end of our remarks, there will be time for your questions. In order to allow more people to ask questions, please limit yourself to one question. After our response we will allow one follow-up question.

I will now like to hand the call over to Jen-Hsun.

Jen-Hsun Huang

Thanks, Mike. Good afternoon, and welcome to NVIDIA’s first quarter conference call. Today we are pleased to report record revenue of $681.8 million and net income of $0.23 per share for our first quarter. Year-over-year, first quarter revenue grew 17% and net income grew 41%. We experienced growth in each of our businesses, GPU, MCP, handheld GPU and consumer electronics resulting in record revenue for the first quarter. We also entered multiple new product cycles during the quarter continuing our leadership in each of the markets we serve. As we move further into the new fiscal year, the growth drivers we outlined at our Analyst Day in March which included the adoption of Microsoft Vista, high definition video, and the launch of Sony PlayStation 3 will continue to accelerate and give us the opportunity for another strong year of growth.

Let me highlight some of our first quarter fiscal 2007 results and achievements. Non-GAAP gross margin reached a company high of 42.5%, an increase of 230 basis points sequentially from the fourth quarter of fiscal 2006 and 650 basis points year-over-year. GAAP gross margin was 42.4% for the first quarter of fiscal 2007. We shipped 8 new GeForce 7 series GPUs for desktop and notebook PCs and now offer a complete top to bottom family of GeForce 7 GPUs. NVIDIA grew share in the performance DX9 and combined DX9 desktop GPU segments from 79% to 83% and from 57% to 60% respectively from the fourth quarter of calendar 2005 to the first quarter of calendar 2006 as reported Mercury Research’s First Quarter PC Graphics Report 2006.

The NVIDIA nForce MCP product line achieved record revenue for its seventh consecutive quarter. nForce MCPs increased their share of the AMD64 segment from 35% to 42% from the fourth quarter of calendar 2005 to the first quarter of calendar 2006 as reported in Mercury Research’s First Quarter Worldwide Chipset Report 2006. We continued to advance our leadership position in multi-GPU technology. The company shipped its first Quad SLI system for desktop PCs enabling 4 GPUs per system. We also brought our SLI technology to notebook PCs enthusiasts.

NVIDIA demonstrated the world’s first GPU-powered game physics solution at the Game Developer’s Conference with Havok, the game industry’s leading supplier of cross-platform physics engine middleware. Lifelike physics will bring a new dimension of realism and interactivity to games. We shipped our first integrated graphics processor (IGP) core-logic solution for AMD-based notebook PCs, the GeForce Go 6100 GPU and nForce Go 430 MCP. The core-logic solution is the industry’s first high-definition IGP to provide hardware accelerated H.264 high-definition video playback. The Professional Solutions Group introduced 11 new desktop and notebook workstation solutions, designed to improve workstation graphics performance and representing the most extensive line of professional graphics solutions in the industry.

NVIDIA and Intel announced a collaboration to bring high-performance 3D gaming and multimedia platform to handheld devices. The collaboration combines the NVIDIA GoForce family of handheld GPUs with Intel’s newest processor family, codenamed Monahans, which is based on third-generation Intel XScale architecture, to develop a powerful development platform to content developers. We successfully completed our acquisition of ULi Electronics, a leading developer of core logic technology. And finally we acquired Hybrid Graphics Ltd., a leading developer of embedded 2D and 3D graphics software for handheld devices. The acquisition will enable customers of both companies to deploy rich graphic solutions for the entire worldwide handheld market.

Let me turn the call over to Marv to discuss our financial results in more detail. I will return to discuss our progress and outlook.

Marvin Burkett

Thanks Jen-Hsun. I would like to begin with some comments about the P&L for the first quarter of fiscal year 2007 and then move to the balance sheet. I’ll end with a few comments about the outlook for Q2.

On the P&L, as Jen-Hsun said it earlier, revenue for the quarter was $681.8 million which is up 7.6% from the fourth quarter. The growth of almost $50 million was led by the GPU business which grew $21 million quarter-to-quarter. Within the GPU business, notebook grew by 34% and achieved record revenue. Desktop also grew slightly in spite of a seasonally down first quarter for the PC industry. MCP grew only 4% which was less than we anticipated but still achieved record revenue for the seventh consecutive quarter. Handheld GPUs grew almost 20% and also achieved record revenue. Memory and other also grew $12 million in the quarter. All of our business segments had some growth quarter-to-quarter. Year-over-year our overall revenue grew by 17% led by MCP and GTU businesses. MCP grew 65% year-over-year and GPUs grew by 10%. Our handheld devices almost quadrupled year-over-year but from a very low base last year. Xbox contributed $44 million in revenue in last year’s Q1, therefore our core business grew 24% year-to-year. For gross margins we achieved 42.5% on a non-GAAP basis, which exceeded even our expectations. The introduction and success of several new GeForce 7 products contributed significantly to the improvement. The GeForce 7 family contributed approximately $245 million in revenue for the quarter at excellent gross margins. This resulted in a noticeable increase in gross margin for our GPU business. We also had very good margin improvements in our handheld GPU business and it is now close to breakeven on an operating income level.

Operating expenses were higher than we anticipated. There are many factors that contributed to this and I will outline a few. Going into the quarter we had not anticipated the acquisition of Hybrid or the hiring of significant number of employees from 3D Labs. These two contributed approximately $2 million of expense in the quarter. Also during the quarter there were significant option exercises by employees, this causes an expense for the company for FICA and other taxes that must be paid upon the exercise. This added about $4 million of unanticipated expense for the quarter. We will get this back later in the year when these employees matches our on FICA. Exclusive of these items operating expenses were still higher than we anticipated, as we were able to hire aggressively in other areas. We added 438 employees during the quarter approximately 200 of these were from ULI and another 70 were from Hybrid and 3D labs. When you put that together with our normal hiring the result was a significant increase in headcount. Headcount at the end of the quarter was 3175.

The GAAP tax rate for the quarter was 17%, as we were not able to include the benefit of the R&D tax credit and so that is renewed by congress. When it does get renewed our tax rate will go down. Our non-GAAP tax rate was 16% and that was also negatively impacted by the lack of an R&D tax credit. GAAP net income for the first quarter of fiscal 2007 includes stock based compensation expense of $23.0 million as a result where adoption of SFAS 123R during the quarter. Our non-GAAP results adjust our GAAP results to exclude SFAS 123R stock based compensation and related tax differences. The net result was GAAP earnings of $90.7 million or $0.23 per share on a fully diluted basis. The shares outstanding reflect a stock split which occurred on April 6 and also reflect the new accounting per dilution under 123R. Under the non-GAAP earnings were $0.29 per share with the shares outstanding accounting for under APB 25, which is consistent with the prior year.

On the balance sheet cash was up to $955 million and reflects that we spend approximately $90 million for the acquisitions of ULi and Hybrid. We also repurchased $50 million of stocks during the quarter. Operating cash flow in the quarter was 50 million. Accounts receivable was up by $73 million and reflects that the quarter was back end loaded due to the new product ramps all of which are now in full production. The aging of the receivables remains very good. Inventory was up $92 million as we started the production of several new GeForce 7 products. The increase in inventory can be accounted for by the new products. Depreciation during the quarter was $24 million and capital additions were $21 million.

On the outlook Q2 is the most difficult quarter to forecast. It is the seasonally lowest quarter of the year for the PC industry, in addition our visibility is limited until later in the quarter. Our expectations for PCs are not substantially different from other companies in the industry. Normally in Q2 our desktop business declines along with the PC industry, and this has to be offset with growth in other areas. For Q2 this fiscal year we believe we can achieve growth in the notebook and MCP businesses and believe this can offset any other declines. Because of our new products we anticipate that our desktop business will be relatively flat. Overall we expect flat revenue. I would like to point out that with flat revenue in Q2 our core businesses would grow 35% year-over-year because last year’s Q2 included $69.9 million of Xbox revenue.

For gross margin our results for the first quarter exceeded our expectations and we will work very hard to hold gross margins at this level for the second quarter. We believe the actual gross margin will be a function of mix and any decline would come from significant revenue growth in lower margin businesses. Consistent with relatively flat sales, we expect relatively flat gross margin on both a GAAP and a non-GAAP basis. Operating expenses, both GAAP and non-GAAP will grow only slightly even though we will have the additional headcount for the entire quarter because of some benefit from the non-recurring cost that were in Q1. If the R&D tax credit is renewed we should expect to see the GAAP tax rate reduced in the second quarter. Thanks and I will turn it back to Jen-Hsun.

Jen-Hsun Huang

Thanks Marv. During the quarter we enhanced our leadership position in to market. In Q1 we successfully delivered our entire family of desktop and notebook GeForce 7 GPUs to our OEM and channel partners. Our new GeForce 7900 GTX has captured design wins with nearly every major OEM offering enthusiast and performance PCs. Our calendar Q1 market share of the performance GPU segment increased from 70% to 83% year-over-year. SLI has become a standard feature in performance PCs. Over 4 million SLI enabled nForce MCPs and over 10 million SLI enabled GeForce GPUs have been shipped creating a large eco system of interoperable SLI components for gamers. According to the Valve Steam Engine which reports user’s systems configuration we have over 98% share of the multi-GPU market. At E3 this week Dell demonstrated their next generation flagship PC powered by Intel’s Conroe microprocessor and our next generation nForce and GeForce technologies. Also at E3 Alienware unveiled the world’s first GeForce 7900 SLI notebook. Over 22 system builders around the world now offer SLI notebooks; we look forward to their transition to the GeForce 7900.

In the mainstream segment we’ve been focused on increasing our share. Whereas we have virtually no mainstream PC OEM wins last year, we are ramping design wins at Dell, HP, Gateway, Acer, Legend, Samsung, Medion, Packard Bell, TCL and others. The result of our design win success is starting to reflect in our segment share. Our calendar Q1 combined desktop DX9 GPU share increased from 54% to 60% year-over-year. We are gaining share in the notebook segment as well. The production ramp of our NASA design win refresh is underway. The notebook GPU product lines achieved record revenue for Q1 and as our OEM designs continue to roll out their new notebooks we expect our revenue and share growth to continue throughout the year.

The DX9 generation of GPU is important to achieve the best experience with the new Microsoft Vista user interface called Aero Glass. Enabled by programmable shaders, Aero Glass will feature transparencies, textures, lighting and shadows making the Windows and objects on our PC look virtually real. John Peddie Research recently produced a research piece discussing the impact of Vista Premium’s Aero Glass on the market. According to report, over 600 million PCs shipped in the last 3 years and are still in service. These are the ones that are the most logical to upgrade with the new Vista operating system. Because of the low graphics performance of integrated graphics chips found in most of the PCs they will not be able to take advantage of the richness and benefits of Vista’s new Aero Glass GUI and graphics-based operating system would be unusable on most of them. It will take a performance level add-in board to pull out the richness built into Vista. When users see a system running Vista on a PC with integrated graphics, and then Vista on a PC with a powerful graphics add-in card in it, there will be no discussion, they will go for the better looking system as they can possibly afforded, those were quotes from the John Peddie Report.

In the coming months, we will witness of the next-generation high-generation video formats. The introduction of Blu-ray disc and HD-DVD will bring high-definition movies to our homes. The BD/HD associations have announced that nearly 100 movie titles will be available in these new HD formats by the end of the year. As a standard for PlayStation 3, millions of Blu-ray players will be available this year, with 6 times the resolution of today’s DVD. Blu-ray disc and HD-DVD is a major advance in resolution and quality from the 7-year old DVD format. The image processing requirement is nearly 30 times that of DVD and will require a special video processor to achieve full performance. Our investment in our PureVideo, dedicated video processors and algorithms will help us bring the HD experience to PC and media center users. We believe we have won every major OEM HD-DVD and Blu-ray design win to-date. Blu-ray and HD-DVD equipped desktops and notebook PCs that incorporate our GeForce 7 GPU and PureVideo video playback technology are going to deliver incredible high-definition movies.

We continue to gain share in the AMD server, workstation desktop and notebooks segments. Our share of the AMD platform increased 6% to 42%. On Tuesday this week, HP announced the HP Pavilion DV2000 and Compaq Presario D3000 thin and light notebooks with the GeForce Go 6150 and nForce Go 430 marking NVIDIA’s entry into notebook integrated chip set business. We are preparing our next-generation nForce pipe on the series MCP for the upcoming launches of both the Intel Conroe Microprocessor and AMD Socket AM2 Interconnect. We will be introducing some new and exciting technologies in the 500 families that will raise the performance bar for the industry.

The digital media revolution is also driving the growth of our handheld GPU business. Downloaded video like episodic TV shows, broadcast digital TV for sports and news. And high resolution graphics for rich user interface, rich user interfaces, and games are driving the demand for handheld GPUs. Our target segments are 3G phones, Smartphones and portable entertainment devices. We believe that the graphics and multimedia capability of our handheld GPUs has put us in the perfect position to benefit from the increasing multimedia demands of Smartphones which was only 17 million units in 2004 and growing to 100 million units in 2006.

The increasing availability of digital media content for 3G has driven demand of our handheld GPUs. Our share of the 3G market grew from 7% in 2005 to 12% this year. In a market that has grown from 72 million handsets last year to an estimated 210 million in 2007. Our newest handheld GoForce 5500 GPU has been designed into DVB-H phones in North America, Europe, and ISDB-T phones in Japan. These are phones that are capable of receiving digital television. Two out of the first three DVB-H Television service launches in the world are based on phones powered by NVIDIA’s handheld GPU.

Because of our dedicated H.264 and WMD processors, we are able to deliver the highest image quality at a power level that will enable several hours of enjoyment, and at E3. Sony announced that the highly anticipated PlayStation 3 will be available in Japan on November 11, followed by simultaneous availability in North America, Europe and Australia one week later on November 17. Sony committed to ship 4 million PS3s by December 31 and another 2 million units by March 31, 2007. There are number of positive industry dynamics taking place this year and we believe our product roadmaps and technology leadership, technology leadership uniquely positioned us to drive these trends and produce another year of strong growth.

Thank you and we will be happy to take your questions now.

Question and Answer Session

Operator

(Operator's Instructions).

The first question comes from Tayyib Shah with Longbow Research.

Tayyib Shah - Longbow Research

Congratulations on the quarter. Can you talk about what, what’s happening in the MCP business, it seems like the share gains against in the AMD platform were kind of flat lesser, is that likely to change in the fiscal second quarter?

Jen-Hsun Huang

First of all thank you. Yeah our market share of the, of the MCP business was below our expectation as well. And there is a variety of theories and I think that this one makes the most sense. We experienced that early on the quarter there was, there were some obsolete inventory that were, were sold by one of our competitors in Asia and these were extremely low cost, low cost products and they were based with integrated graphics with AGP. And so I think that reduced the overall market for our products, but it did increase the demand for GPUs because those, the integrated graphics in those products were simply too obsolete, and so we experienced an increasing demand of entry level AGP, GPUs as a result of that. Now my sense is that, that’s not going to continue but that’s our estimation of what happened in Q1.

Tayyib Shah - Longbow Research

Okay and then if I can ask about the margins, can you talk about the opportunity for your 7300 product line in the value segment replacing your 6200 products, how rapid that transition is going to be and what does that do for your overall margins?

Marv Burkett

Well easy answer is that it improves our margins because the margins on that type of product are better than the GeForce 7 family than they are in the GeForce 6 family. How rapid we can make that transition I don’t think its much a matter of production as it, as it has market acceptance.

Tayyib Shah - Longbow Research

Okay thank you.

Jen-Hsun Huang

Thank you.

Operator

Your next question comes from Randy Abrams with Credit Suisse.

Randy Abrams - Credit Suisse First Boston

Yes good afternoon guys. Wanted to see if you can pull up on the revenue guidance I think you made some flat desktops and then up notebooks, and chipsets to get to a flatter role is that employment some of the smaller businesses like handset and other declines or maybe you could clarify that over?

Marv Burkett

Yeah I don’t think that you should take into that that we expect a decline in handset. Remember the memory and other was a fairly large number in Q1, we don’t know what’s going to happen to that in Q2. If that number did not go down and desktop did not go down I think that we can achieve revenue growth but there is just a lot of unknowns along those lines.

Randy Abrams - Credit Suisse First Boston

Okay and maybe the follow-up question, just on the inventory, maybe when if you go into, again I think you met new products ramping. But wanted to understand just the driver of building inventory, if the revenue trajectory is roughly flat in the coming quarter and is there some motivation from tighter supply to form your back end without inventory at this stage?

Jen-Hsun Huang

Yeah that the way to think about that Randy is that, Q1 was our product transition quarter and we transition down our GeForce 6 family and we, ramped up GeForce 7 family. And typically, in the beginning of a product ramp, we want to be prepared to make available as much of our products to the marketplace as possible and give our OEMs and the channel the opportunity to sell their pipelines. And so, that’s, this is pretty typical stock and its, its reflective of how we make product transitions. I mean the most important thing is just make sure that we have enough 7900s and 7600s and 7300s for the marketplace.

Randy Abrams - Credit Suisse First Boston

Okay, thanks a lot.

Operator

Your next question comes from Mark Edelstone with Morgan Stanley.

Mark Edelstone - Morgan Stanley

Thanks a lot. Nice job on the gross margins, guys.

Jen-Hsun Huang

Thanks Mark.

Mark Edelstone - Morgan Stanley

Let’s see a couple of quick ones first Marv, can you give us what the NRE was in the quarter and what you expect NRE to do in Q2?

Marvin Burkett

Roughly, $20 million to $25 million in the quarter, around numbers 23 that was the Sony NRE and licensing together. Then your second question is what you are expected to do, roughly flat.

Mark Edelstone - Morgan Stanley

Okay, great. And then Jen-Hsun to me under stand all the issues here that you’d look for the current quarter, can you just give us your senses to what see here the most important drivers as you look at the second half of the year and maybe you can try to put those in the context of seasonality. It seems like, you’d actually have quite a few things that ought to give you a better than seasonal lift even some of the things you’re approaching right now.

Jen-Hsun Huang

Yeah, we entered Q2, we always enter Q2 with caution and as just, there is a lot of markets that are taking a pause but we have a lot of good things going for us, GeForce 7 is really a terrific architecture and we continue to ramp into the marketplace with GeForce 7. We have the benefit this year of also winning a lot of the OEM design wins that we simply didn’t have last year, both on the desktop as well as the notebook segments. And so we’ll be ramping into those OEM design wins. We also have, have some pretty terrific handheld GPU products. We have the benefits of PlayStation 3 ramping, they have obviously announced pretty wide availability and simultaneous worldwide launches of, in the November timeframe, which means that that at this point they are clearly manufacturing at full throttle, and so you have that going for us. And then, our MCP business continues to grow. Its, our expectation is that this year over last year we should, we should be in a position to grow substantially in MCP. Two reasons, one of which is when Intel’s Conroe microprocessor does well, it creates a larger performance segment and we have a strong presence in the performance segment as you know, and so that that should help us. And then secondarily, this is our first year with, first full year with integrated graphics built on, built on the desktop as well as notebook computers and so this is very exciting. And then, the last one, it’s not insignificant, it’s blu-ray disc in high definition video. This is first major consumer electronics transition in 7 years. And if you take a look at what’s been going on in the consumer electronics world over the last 5 years or so, it’s really been about High Definition displays and flat displays. Well, finally, they have something they can really drive it and that’s blu-ray disc and HD-DVD. And the processing requirement for BD and HD are so high compared to DVD that you really need to have a dedicated video processor, and this is something that we been talking about and offering to the marketplace. Obviously, with standard definition it was kind of hard to demonstrate the value proposition, but now with HD becoming the value of our video processor is crystal clear, and it’s reflected in all the design wins we have from media centers, and notebooks and PCs that are going to out in blu-ray and HD-DVD. So, I think that we’re positioned than ever before. We have more product drivers and market drivers than ever before, and if we continue to execute, I think that we’re going to have a pretty good year.

Mark Edelstone - Morgan Stanley

That’s great. Just one last one if I could, based on this opportunities should we expect inventories to increase again in this quarter as you basically get prepared for the second half of the year?

Jen-Hsun Huang

Our expectation is not, it just that when we’re ramping new products, we have to make sure that we help our OEMs and help our channel partners to fill their pipeline. And so, there is always that initial surge of supply, to just supply everybody with GeForce 7s. And so, my expectation is that once we get through, get going here we are going to level out to typical ways of managing our inventory.

Mark Edelstone - Morgan Stanley

Okay thanks a lot guys.

Jen-Hsun Huang

Yeah thanks a lot Mark.

Operator

Your next question comes from David Wu with Global Crown.

Hun Lee - Global Crown Capital

Hi, this is Hun Lee calling for David Wu, thank you for taking my question, I have a few question, regarding you said for the gross margin upside, primarily due to the GeForce 7 increase in sales, and I have been checking up on a few, online websites, and I have seen some shortages so that doesn’t quite match the picture that you provide. So could you please give some more clarity to that?

Jen-Hsun Huang

Well at some level I think it’s perfectly aligned with the picture we have provided. We just went through a production transition in Q1. And we ramped down the 6800 and the various GeForce 6 products and we ramped into the GeForce 7 products. And the demand has been really strong. The 7900 has been a product that we have had a hard time catching up with. And that’s one of the reasons why we are building aggressively to fill the market pipeline and to meet the market demand. And I think as I said in the prepared comments, that our performance segment, GPU market share is increasing. And so it reflects that the demand for GeForce 7900 is quite high. And the 7600 is incredibly high. And so you just got to take that into consideration. And the other thing to remember is that SLI takes 2 GPUs per PC. And so the number of gamers in the world and the number of game enthusiasts haven’t declined, and in fact, they have probably grown. But now they consume 2 GPUs per PC. We have always felt that SLI would increase our TAM and I think in a lot of ways, it has.

Hun Lee - Global Crown Capital

Okay, that makes a lot more sense to me now. And another question is for your upcoming nForce5 or the Tritium chipset or could you please comment a little bit about the performance and the gross margin for those? Thank you.

Jen-Hsun Huang

Well, our next generation core logic, our next generation MCP nForce5 will unambiguously be the highest performance core logic in the world. And that’s what it was designed to do and that’s our expectation. And it’s intended to bring some new exciting features at a marketplace that the market’s never seen. Give me a chance to launch that product and I’ll come back next quarter to report on the things that we said.

Hun Lee - Global Crown Capital

Sure. And how about the gross margin, are they going to be above, below, or at the popular level?

Jen-Hsun Huang

Above.

Hun Lee - Global Crown Capital

Okay, thank you.

Operator

Your next question comes from Jason Pflaum with Thomas Weisel Partners.

Jason Pflaum - Thomas Weisel Partners

Yeah, good afternoon and good job guys.

Jen-Hsun Huang

Thanks Jason.

Jason Pflaum - Thomas Weisel Partners

Just to circle back again on the inventories little bit, if you could just help on the composition of the composition of those inventories again and the fact that MCPs is kind of little bit lighter than you expected it was out partly reflective of the build there as well?

Marv Burkett

Yeah I think that’s unique take a look at, we grew inventory round numbers, $19 million quarter-to-quarter. But on the new products we grew inventory roughly $115 million. So of the older GeForce 6 product suite decreased inventory commensurate with what we are trying to do. We did build a little bit more MCP inventory that we anticipated because the MCP sales didn’t achieve what we thought. So there is a little bit more there. But I think that what you should understand is that in general the growth in inventory was driven by the new products.

Jason Pflaum - Thomas Weisel Partners

Okay. And then just can you give us a sense of what portion of your revenues, are going to distribution this quarter? You continue to look that down and was that also a contributor perhaps in holding a little bit more inventory?

Marv Burkett

Yeah I mean it does contribute as we take customers more direct. I don’t know that it was significant though. There two major distributors that everyone focuses on for us even in Atlantic we’re below 12% of our business together, each of them below 6%.

Jason Pflaum - Thomas Weisel Partners

Okay. And then just ask question on the handset side of your business, obviously saw some nice growth there this quarter and good momentum. Can you just characterize or give us a sense for the breadth of some of the design wins that you have now going into the second half, maybe just give a flavor for how many the top shooters maybe shifting to there?

Jen-Hsun Huang

I guess we have design wins with 4 to 5 top handset manufacturers in the world. Most of our handset design wins are focused on 3G cell phones. Many of the new handset design wins are now being designed into digital television cell phones and smart phones. Those are really our target markets. We haven’t played much in the basics graphics GPU business in handsets and there the reason for that is just there is not just much value to add. We tend to focus all our energy on the really rich multimedia capabilities like digital television or video playback or digital camcorder functionality or digital cameras and of course graphics. And so, we tend to focus a lot of our efforts around those types of applications and we are trying to play into emerging and growing market trends. And this is a, we have been talking about how we believe that your handset device is going to become one of your most important computers in your life and increasingly becoming less perceived as just a modem or just as a handset, as a telephone and I think that vision is really playing out and if you believe in that vision then you have to believe that graphics and multimedia technologies are going to be important in that that's really our focus.

Jason Pflaum - Thomas Weisel Partners

Okay. Thanks guys.

Jen-Hsun Huang

Yeah. Thank you.

Operator

Your next question comes from Nicholas Aberle with Caris & Company.

Nicholas Aberle - Caris & Company

Good afternoon. Just why don't you just touch base a little bit more on the performance mainstream segments for discrete desktop, based on our analysis really seems like you guys have got a nice competitive advantage there, superficially on the 7600 products. Can you talk a little bit about the strategy in that particular segment of the market, and some of your expectations for market share gain there, over the course of the year?

Jen-Hsun Huang

I guess our strategy is to build the living daylights out of it.

Marv Burkett

We can't.

Jen-Hsun Huang

Yeah, that's a, it's a pretty sizable market and it's an interesting segment because the volumes are large and also the ASPs are high. And so the technology requirements are pretty demanding and the gamer want the absolute best. And the distribution channel wants to have the best brand and wanted the price they believe and they know they can sell. And so the 7600 family is really perfect for that and it's, follow-on to our 6600 family and so my expectation is that we will do better with 7600 than we do with 6600.

Nicholas Aberle - Caris & Company

Perfect. And then just one more quick follow-on, you guys did touch base on the impact of delayed just operating system, more chatter about that being pushed out even further into mid’07. Does that change you guys, outlook on the effects of that operating system launch at all?

Jen-Hsun Huang

Not really, I think that ending end in the grand scheme of things this is what this is the first major operating system upgrade in quite a long time. I think it's probably close to 7 years, isn't it. And this is the first operating system in the history of humanity that requires a GPU. And as more and more applications get loaded with more and more wedges, and more and more of the Vista Aero Glass capabilities, the graphics demand on your desktop is. On your desktop is going to just continue to increase and there is just not been a single person that is ever seen it that says I can go back. Everything is better, the fonts are better, the resolution is better, the way that the window glides across the desktop is just, everything is just delightful about it and so my sense is that that this Aero Glass is going to create quite a bump for GPUs for quite some time. And so were looking forward to that. We are disappointed as anybody does, that is surpass, go surpass this year but it doesn't fundamentally change anything in the final analysis.

Nicholas Aberle - Caris & Company

Perfect good luck and keep you.

Jen-Hsun Huang

Hey thanks a lot.

Operator

Your next question comes from Quinn Bolton with Needham Incorporated.

Quinn Bolton - Needham Incorporated

Let me add the congratulations on a great margin. Wanted to see if you just look back historically over the various generations of GeForce processors, you guys tended to match out it, sort of match market share readers an performance from the overall desktop segment, when you guys were getting pretty high over 80% now in the performance segment, 605 of the discreet, historically have you gotten a lot higher than that?

Jen-Hsun Huang

Yeah I guess so, I mean, I think that, I am trying to think here. Our focus really isn't just share. We have always been since the beginning of our company focused #1 on increasing the market and it’s about bringing new ideas and new technologies and new features and capabilities to this marketplace and also about expanding the reach of it. One of the best things that we ever did was, was working with Microsoft and folks out in Redman to talk about the importance of the GPU and helping them understand how it could really transform the computing experience. With that's going to increase the markets of GPUs. Our SLI increased the TAM of GPUs. This recent addition of a feature that we added to our GPUs called Physics, it's going to make your SLI system that much more valuable. You could either use both graphics for, both GPUs for game rendering or if particular has a great deal of physics you can use one of the GPUs for physics processing. There is sort of versatility in the new capability that we bring to the marketplace. We just continue to increase the scope in the reach of the marketplace. So, that's always been our focus just to continue to add more value.

Quinn Bolton - Needham Incorporated

And then second I might have a missed a bit I just wonder if you could make any comments sort of the how the workstations business quarter-over-quarter was that another record?

Jen-Hsun Huang

We grew slightly and had a record quarter.

Quinn Bolton - Needham Incorporated

Great, okay, thanks.

Jen-Hsun Huang

Thank you, Quinn.

Operator

Your next question comes from Pranay Laharia with Deutsche Bank.

Pranay Laharia - Deutsche Bank

Hi, a question for you Marv, can you please rank your segments, sort of MCPs, notebook graphics, desktop graphics, workstation, cell phones in the order of gross margin growth that you expect to see in those segments from here onwards through the end of fiscal '06, or fiscal '07?

Marvin Burkett

Well, wow.

Jen-Hsun Huang

Hey Pranay, I think that was like 6 questions.

Pranay Laharia - Deutsche Bank

Okay, I will abbreviate that. Rank your segments in the order of gross margin growth from here onwards?

Marvin Burkett

I don't even, you even broke it down between segments…

Pranay Laharia - Deutsche Bank

Okay, just combined GPU then…

Jen-Hsun Huang

Very good question…

Marvin Burkett

The desktop GPU business should increase gross margin because of the GeForce 7. I mean, margins are excellent of GeForce 7, beyond that, are we going to increase gross margins in workstation, I don't know they are pretty high right now. Are we going to increase gross margins in notebooks? Yeah because, it's going to transition to GeForce 7.

Jen-Hsun Huang

MCP should have some gross margin left and also on the other hand has a deeper market penetration which was against gross margins, because the gross margin lift comes from new generation of products that you will be launching obviously, and then on the other hand, you have got our integrated graphics ramping into desktops and notebooks, let's see what was it, the handsets…

Marvin Burkett

So you have a lot of things going in different directions like Jen-Hsun said. The individual components of MCP might be growing, but if we ship more of the integrated, it will have a negative effect on the whole business unit. Handheld, gross margins have been pretty good, are we going to be able to sustain it, we will see.

Jen-Hsun Huang

I think that the question that you asked ultimately is, highlights the fundamental dynamic for all companies who are simultaneously pushing new technologies and new features which helps gross margins as well as capturing more of the market, bringing that technology to more people which tend to commoditize the technology. So we have those fundamental tensions in our business like everybody else, and hopefully overall we are improving gross margins as a company, our gross margin improvement in the company is not just coming from new products. I mean it's coming from just a corporate wide operational enhancement and drive in the company and its, our business is extremely high velocity, so its not easy to do what we are doing, but we have to create a lot of new ideas to enhance our operational performance, and so that's where we great at those things, coming up with great ideas.

Pranay Laharia - Deutsche Bank

Okay very good. Just a quick follow-up if I may. Trying to reconcile some of this impact, it seems like all the leading integrated graphics vendors pulling yourself ATI and even Intel with broad warrant test line, I was stating that their chipsets, integrated graphics chipsets are either already they’re premium capable or they will be very, very soon. And despite these plans, it seems like you guys still think that to speed traffic it's going to take bump up with Vista launch now. Can you help me reconcile these two views on some of these Vista premium capability claim is it just hollow or not up to mark?

Jen-Hsun Huang

Absolutely you asked a really good question, I’m glad you asked it. The way to think about it is this, today on non-Vista just Windows XP the performance experience of your Windows experience and my Windows experience is identical and I don't even know what you have. Everybody's Windows XP experience is identical because the graphics technology far exceeds anything that Windows XP requires. However the moment that Windows Premium, Vista Premium and Aero Glass comes out people who have GPUs will have a noticeably better experience, noticeably better experience I mean you would have to fallen asleep to not notice that you have a noticeably better experience, its almost no different than video games which based on the same technology. So you would expect similar dynamics that somebody with a GPU is just going to have a better experience with the game then somebody who has who doesn't have a good graphics technology and so you are going to have exactly the same thing. Now when somebody can actually notice the different when a consumer can get an appreciable better experience with a GPU those are the type of dynamics that we love. We’re encouraging to by a better GPU, we’re encouraging incursion to upgrade and we're encouraging to buy a GPU from the retail market to enhance their computer all of that is good for us.

Pranay Laharia - Deutsche Bank

Okay thanks.

Jen-Hsun Huang

Yeah thanks a lot.

Operator

Your next question comes from Rick Schafer with CIBC World Markets.

Dan Morris - CIBC World Markets

Hi guys this Dan Morris calling in for Rick first of all, good quarter.

Jen-Hsun Huang

Thank you.

Dan Morris - CIBC World Markets

Just a house keeping question you mentioned that high grade and 3D effects added about 2 million to OpEx, could you also quantify how much you added to OpEx during the quarter and what contribution that was on the top line from the acquisitions?

Jen-Hsun Huang

Just as a quick clarification that was 3DLabs.

Dan Morris - CIBC World Markets

Okay.

Marvin Burkett

For the OpEx.

Jen-Hsun Huang

For you and for all of us, this brings back memories.

Marv Burkett

Yeah Hybrid and 3DLabs, the people that we picked up from there, plus the amortization associated with Hybrid cost us about $2 million in the quarter. We acquired ULi sometime in February so we picked up roughly 2 months, little over 2 months worth of ULi. It contributed somewhere around 8 to 10 million in revenue and about 3 to 4 million in expenses.

Dan Morris - CIBC World Markets

Okay, great. And then a follow up, there has been a lot press recently about physics and specifically physics processors. You have also added few press releases and demos of your mechanic and Intel gate. I was wondering if you could talk more about your views on the discreet solution and also elaborate on some of these announcements and physics plans?

Jen-Hsun Huang

Sure. I guess what I will do, I will elaborate on physics and why it’s so good. I mean obviously if you take a look at most of the environments that you see in video games and others the environment is by and large static. I mean there are some movement of water and leaves and what not, but they are contrived. And so I think that physics and applying physics to all of those objects in the environment in the world will just make the world look a lot more alive. And whether the way you interact with it or just the way you look at it, so, physics is going to terrific. The second thing is the more objects that you create, the more objects you have to render and so from a graphics perspective that's really terrific as well. It just creates more workload for us to have to go and overcome and we like that. With respect to physics processors it’s hard to say exactly whether there is a unique market for it. But that's not what we are too concerned about it. We wish those guys well. Anybody who wants to build physics processors as well and it's good for the gaming industry. But from our perspective the GPU is a completely programmable device and it does, floating point and mathematics probably faster than any processor know to man since the beginning of computing and for us to redeploy the physics processing is a wonderful use of the investment that's already been made.

Dan Morris - CIBC World Markets

Thank you.

Jen-Hsun Huang

Thank you.

Operator

Your next question comes from Krishna Shankar with JMP Securities.

Krishna Shankar - JMP Securities

Yes, you alluded to be chip business being somewhat weaker because some IGP chipsets having a different pricing, do you feel that the if the cemetery is there, and have been worked off and we are returning to a more demand supply environment, in the AMD platform market, or whether this refer to just AMD platform for both Intel and AMD?

Jen-Hsun Huang

At the price of those, the fact that it was so far below market pricing and frankly, so far below cost, I can't imagine anybody enjoying that kind of business unless its really just to get rid of the excess inventory. And so my sense is that that it’s, it's not going to happen on a regular basis. But we have to keep our eyes on. But the important thing to realize is that we know, we are not just offered core logic as a company, we also our GPU supplier and when those integrated graphics are sold they tend to be, they tend to be very, very low end and have to create some opportunity for us to sell a discrete GPU. And so it probably works its all, works itself out in the grand scheme of things, but on balance we still prefer people go to market.

Krishna Shankar - JMP Securities

And then just a follow-on question, you talked about the requirements for discrete, graphics on desktop, do you see an equally comparative need for desktop and notebooks, so will the caller excitement for notebooks will keep the trend towards integrated graphic there?

Jen-Hsun Huang

I think you have compelling desire in both. And I think the, of you want to dedicate a processor at something, always will do a better job than a general purpose processor in a power environment, power sensitive environment and so that the discrete GPU will do a wonderful job for you as well as do a good job monitoring power as we go. My sense is that this is going to be good for GPUs all the way around.

Krishna Shankar - JMP Securities

Great. And my final question Marv, can you give me some sense for how to model the licensing and raise your revenues going forward for PS3 in the August and November quarter?

Marv Burkett

Well, certainly for Q2, we expect that Q2 will just be a combination of NRE and license fee and the numbers that I gave you for outlook we do not incorporate any expectations for a royalty. I would expect that we will receive royalty income in Q3 the magnitude with, give you a number right now. So Q3 would be more of the same plus royalty.

Krishna Shankar - JMP Securities

Okay thank you.

Jen-Hsun Huang

Thank you, Krishna.

Operator

Your next question comes from Simona Jankowski with Goldman Sachs.

Simona Jankowski - Goldman Sachs

Hi thanks very much. Can you tell us what percent of your GPU sales in the quarter that you spent, it was from the GeForce 7 family, and do you have an estimate as to what percent of sales for GPUs is going to be GeForce 7 in the second quarter?

Marvin Burkett

Well, I think I said in my comments Simona that we spent more than $250 million in GeForce 7 in the GPU business in Q1. And so that was well more than 50%.

Simona Jankowski - Goldman Sachs

Okay, and how much do you think that will be in the second quarter?

Jen-Hsun Huang

It should be a lot more.

Simona Jankowski - Goldman Sachs

Okay. It just seems that with your inventory build of $150 million of new products, that would kind of growth up to $330 million in revenues of the new products, if you kind of apply 45% gross margins, so would that be kind of what you guys are looking for, that seems like it will be a pretty aggressive number?

Marvin Burkett

Well I mean, obviously it depends on the market, but there is nothing wrong with the kind of numbers that we have laid out there. The GeForce 7 is a very good product finally.

Simona Jankowski - Goldman Sachs

Okay, and then maybe just somewhat relatedly, when you are expecting your desktop business to be roughly flat in a PC environment that's likely going to be down, are you expecting that to be a function of share gains or higher blended ASPs or both?

Jen-Hsun Huang

Share gains.

Simona Jankowski - Goldman Sachs

Okay. And then just lastly for your gross margin guidance were flat, it seems like with such a significant mix of your GeForce 7 business as a percent of the total, and then the same thing happening in notebook, what is going to be driving it down to kind of flat gross margin in the second quarter?

Marvin Burkett

Mixed, we expect MCP to do better.

Simona Jankowski - Goldman Sachs

Okay. And you think that's going to be in a thought that all of the other notebooks in the desktop GPU transition?

Marvin Burkett

Yes.

Simona Jankowski - Goldman Sachs

Okay, thanks very much.

Jen-Hsun Huang

Thanks Simona. So previously I had answered a question incorrectly, I was asked whether workstation revenues was a record, we broke 100 million again, but it was not a record. It was down quarter-to-quarter by 1%.

Marvin Burkett

Yeah, down close.

Jen-Hsun Huang

So, it was basically flat.

Operator

Ladies, we have reached the end of the allotted time for questions and answers this afternoon. I would now like to turn the call back over to Jen-Hsun Huang for closing remarks.

Jen-Hsun Huang

Thank you all for joining us today and we look forward to reporting our progress for 2Q this month.

Operator

Ladies and gentlemen, we do appreciate your joining us today. This does conclude our conference call and you may now disconnect.

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