There's a multibillion-dollar company moving into the chip business: Microsoft.

According to sources, the Redmond, Wash.-based software giant will more actively participate in the design of the brains for the next version of its Xbox gaming console, tentatively called Xbox Next. By switching from using relatively standard parts to more customized silicon, the company can better optimize its game console, due in 2005. At the same time, the move potentially gives the company a toehold in a completely new market.

"It is clear that Microsoft wants to get a lot of their DNA into it," said Richard Doherty, director of research company The Envisioneering Group. One reason for that involves hacking incidents. "They sure don't want to have a situation where an Xbox can be turned into a PC," Doherty said. Another is that Microsoft can squeeze better performance out of chips by being involved on the front end of the design process.

For the original Xbox, Intel and Nvidia sold chips to Microsoft that were largely identical to semiconductors the two chipmakers have also sold to the general PC market.

With Xbox Next, Microsoft is licensing graphics technology from ATI Technologies, processor technology from IBM and chipset technology from Silicon Integrated Systems (SIS). Microsoft will then work with these companies to fashion customized chips, sources said.

The arrangement will likely mirror Sony's relationship with IBM and Toshiba to create the Cell processor slated for use in the next big release of the PlayStation game console, said analysts and sources close to the companies.

Microsoft will likely ink deals with one or more semiconductor foundries to manufacture the chips for the new Xbox design, said people familiar with the deal. "Manufacturing is not part of the agreement yet. It is up to them what they do with manufacturing," an IBM representative said.

Microsoft, which announced the IBM and SIS deals last week, refused to comment further on its plans. Chairman Bill Gates is expected to discuss Xbox plans at the CES show in Las Vegas this January, Doherty said.

Although chip customization can create risks, it will enable Microsoft to optimize performance inside the console. The company has also been wrestling with Xbox hackers, who've been able to turn the $179 console into a fully functioning computer.

In a sense, "Microsoft is becoming a fabless semiconductor design firm," said Peter Glaskowsky, editor in chief of The Microprocessor Report. These companies--without their own chip-fabrication factories, or "fabs"--design their processors but outsource manufacturing to foundry companies. They also often license design expertise and intellectual property from others. Microsoft "had very little to do" with silicon design for the first Xbox, said Glaskowsky.

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