Microsoft Fights Back over Its Spending Plans

By Peter Galli  |  Posted 2006-05-05

Microsoft Fights Back over Its Spending Plans

Microsoft, which took a Wall Street drubbing after announcing on April 27 that its spending plans would impact future growth, ended this week on a far better note than the last one.

Much of that is due to the fact that Microsoft executives have spent the past five days explaining to concerned staff and shareholders why such bold spending is necessary.

The spiral of the past eight days was set in motion on a media and analyst call to discuss Microsofts third-quarter financial results as well as the outlook for the last quarter and the next full fiscal year.

During that call, Rick Sherlund, a financial analyst with Goldman Sachs, asked Chris Liddell, Microsofts chief financial officer, if Microsoft was ramping up its online business and building a "Google or Yahoo" inside the company, given that its expenses were about $2.4 billion more than he had estimated.

Liddell responded that while he would not get to the same $2.4 billion number, "I would characterize this as being a broad-based approach across multiple fronts. I dont think there is any Trojan horse there that we havent talked about that is sitting below the surface and that we dont want to talk about," he said.

Click here to read more about the business challenges and opportunities Microsoft faces in 2007.

The admission of that level of spending and its effects sent Microsofts share price southward.

It slumped 11 percent, or $3.12, to $24.13 on April 28, the biggest single-day drop since Dec. 15, 2000.

The shares then started the week of May 1 slightly better at $24.50 before slipping further over the week. The stock was last trading at $23.80 at 4 p.m. EDT on May 5.

This share price fall slashed billions off the market capitalization of the company and millions of the holdings of some staff, a fact which probably did not bother Bill Gates, Microsofts chairman, chief software architect and largest individual shareholder.

In fact, Gates said at an advertising event that he wished he were not the worlds richest man as "nothing good comes out of that."

Next Page: Rattle and tempest.

Rattle and Tempest

However, other shareholders and Wall Street analysts were rattled by the news, particularly by the lack of explanation about where the money was going to be spent and why, prompting Microsoft CEO Steve Ballmer to release a memo to staff members explaining the move and trying to calm their nerves.

"To ensure that we win where we see opportunities and can respond with speed when the marketplace changes, we made the decision to ramp up investments during Q3 in a number of key areas…we also provided guidance for Q4 of this fiscal year and for FY07, that indicates our willingness to be aggressive when making investments where they are strategic for future growth," he said.

While acknowledging that "the bottom-line result of these investments created a shift in our near-term profitability that was a surprise and the change in our stock price reflects this," he was his usual upbeat self, concluding that "Ive never been more confident that we are making the right investments."

To read more about exactly where Microsoft plans to spend all this money, click here.

But, after the initial tempest, some Wall Street analysts are supporting Ballmers position.

Charles DiBona, an analyst at Sanford C. Bernstein & Co in New York, said in a research note released this week that "the overwhelmingly negative market reaction to the recent surprise announcement of greater-than-expected FY-07 operating expenses is somewhat exaggerated and a reaction in part to the poor communication of that news rather than to the actual ramifications and implications of that spending."

Microsoft remained strategically well-positioned versus its traditional competitors and was in a reasonably solid position to fight off its newer rivals, he said, adding that some incremental spending was essential given the risks to Microsofts current business and the opportunities to expand its franchise.

"We believe that the spending, rather than being purely defensive (though there is an element of that) and even wasteful, may in fact bring incremental upside to the company," he said.

He also made clear that he believes the Google competitive threat is about platforms, not about advertising or applications, given its estimate that search ads represented just $376 million dollars, or less than 1 percent, of Microsofts revenue over the last 12 months.

In fact, the entire MSN division accounted for just $2.3 billion or 5.4 percent of Microsofts total revenues, DiBona notes, adding that the opportunity cost of losing that business and the threat of losing the existing business to Google hardly would qualify Google as Microsofts top competitor.

But that is what Microsoft executives have been saying publicly. In a wide-ranging interview at Microsofts Worldwide Partner Conference in 2005, Ballmer said the biggest challenge facing Microsoft, and what keeps him up at night, is competing with search specialists such as Google and Yahoo.

"When you talk about our greatest competitors, you have to look at those companies doing things to change the future," Ballmer said.

"We just launched our own search product with our own search technologies some months ago, and we are in the game. I dont underestimate that [it] is going to be very hard, and we are very focused. The thing that is going to be the hardest to make progress on will be to take market share from Google and Yahoo," he said at the time.

To read more about Ballmers thoughts on the competition, click here.

But, to Sanford Bernsteins DiBona, the real risk is around Google becoming a platform for service-oriented applications and, as a result, potentially disrupting the core Windows client franchise, "with the impacts on other key franchises such as Office and even the server business being secondary effects of that greater struggle over the core platform," he said.

The idea of that must send shivers down the spines of executives like Ballmer and Gates, who would much rather have shareholders believe the fight with Google is about advertising revenue than about its core Windows franchises.

But, even with that being said, DiBona is bullish about the potential further downside for the stock, saying that "at current levels, we feel that the stock represents a solid fundamental value with limited downside from here and the opportunity for substantial appreciation.

"We continue to believe that Microsofts share price undervalues the true growth potential of the company and view this as the most compelling long-term investment opportunity in our coverage."

Now those words must be music to Gates and Ballmers ears.

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