[link|http://www.bloomberg.com/apps/news?pid=10000087&sid=a690hICAH5Wk&refer=top_world_news|Bloomberg]:

April 28 (Bloomberg) -- Microsoft Corp. shares had their biggest drop in more than five years after the world's largest software maker said it will increase spending on its Internet unit to stem customer defections to Google Inc.

The stock tumbled 11 percent on the most volume ever for Microsoft, erasing $31.6 billion in market value. At least five analysts, including Morgan Stanley's Mary Meeker, cut their ratings after the forecast, issued yesterday with the Redmond, Washington-based company's third-quarter earnings.

The spending surprised analysts, who said Chief Executive Officer Steve Ballmer may be investing too much at the expense of profit. Ballmer's decision to pour money into his MSN Internet unit probably will lead to an 18 percent increase in costs, to $22.3 billion in 2007, said Goldman, Sachs & Co.'s Rick Sherlund. Sales may rise 14 percent over the same period.

[...]

The forecast "snuffed hopes" of an expansion in profit margins next fiscal year, Meeker wrote today as she cut her rating to "equal weight." Credit Suisse's Jason Maynard said Microsoft "dropped an EPS bomb on investors" and cut his estimate for the share price to $27 from $29.

"We're not that bad in forecasting expenses," Sherlund, the top-ranked software analyst by Institutional Investor magazine, said on the conference call yesterday. "It sounds like you are building a Google or a Yahoo inside this company."

[...]

Now expenses will rise further. Higher-than-expected Xbox costs will continue in the fourth quarter, Chief Financial Officer Christopher Liddell said in an interview. Ballmer also has decided to invest in hiring and research and development in several areas that have potential for future growth at the expense of next year's earnings, Liddell said.

Beginning this quarter, Microsoft is raising investment in its MSN Web unit in a bid to catch Google, which is taking market share in areas such as search and maps. Microsoft is shelling out more for research into communications, business intelligence, security, high-performance computing and services, Liddell said.

[...]

"The investment seems smart, but for the payoff I need to get a little bit closer to it," said Robert Mattson, an analyst at Gartmore Global Investments in Philadelphia. The firm manages $89.7 billion. "There's nothing coming up for six months. If there's nothing to get excited about, then who cares?"

MS's fiscal year is July 1 to June 30, so their Fiscal 07 starts on July 1, 2006.

Several things bother me about this story - things that don't seem to add up:

1) Everyone quoted is upset about increased expenses and forcasted drop in earnings per share. Does a drop in EPS over the next 14 months make sense when XBox 360 is supposed to be taking off after a slow start, when Windows Vista will becoming out, when Office Live and Windows Live and so forth will be coming out? Surely there will be a spike in increased sales in November-December (XBox 360) and in January-February (Vista, Office). They may not be the run-away hits that MS was used to in the mid-late 90's, but I can't believe that there won't be some substantial increase in sales. The PS3 has gotten terrible press for months (too late, too expensive), so MS should be sitting pretty on the game console front. Why aren't they? While there are stories about companies defecting from Office to OO.o, I have to believe that MS will work very hard to keep their customers. Are things really that bad for them on the Vista and Office fronts? Why are these analysts discounting these issues? Are these sales going to be so pathetic as to be unable to cover $3B in increased costs and not maintain the EPS?

Microsoft is not sitting pretty on the game console front because they are deliberately running a price war on game consoles to try to undermine Sony. I'm not sure whether they are selling the XBox 360 at a loss like they did the first XBox, but they certainly don't make much on it. In any case good sales there are bad news for Sony, but aren't good news for Microsoft in the near term.

Were I an analyst I would be aware that software schedules often slip, and I'd take seriously the possibility that Office or Vista will not release when Microsoft thinks that they will. Or alternately that something will be released, but it will be so bad that it will undermine Microsoft's market share.

And long-term, of course, anyone who understands The Innovator's Dilemma knows that Open Office or some relative will eventually kill the MS Office monopoly. It sounds so simple to "do something about it", but actually doing it is a surprisingly tricky business problem.

2) Re the last quoted paragraph - 6 months from now is only just November 1. That's just before I would expect to see a substantial increase in sales. Does it make sense to dump the stock based on such a short outlook? I thought that stock analysts looked 6-9 months out, not 3-6. It seems very short sighted.

It doesn't for me. If there were things projected to come out in the next 6 months, even if they slipped, they would likely be there for Christmas. But if Microsoft is aiming for November and slips a month, the channel won't be stocked in time to make Christmas and Microsoft loses that revenue. In short, the substantial increase in sales that you're looking for is at risk, and the risk to it should start lowering valuations now.

3) I guess Ballmer is feeling desperate since his proposed deal with AOL fell through and [link|http://news.com.com/AOL+to+stick+with+Google/2100-1030_3-5998600.html|AOL went with Google instead].

For good reason. :-)

4) Why is there no mention of Vista and Office? Are those dead or dying business units?

Judging from betas, Vista will be DOA. For Office, Microsoft has not managed to come up with a new compelling feature in that franchise in years. It is unlikely that they'll succeed this time either. Without a compelling feature, they'll get replacement sales but not a big sales spike.

Maybe I'm missing things, but the cynical side of me sees this as an attempt at sandbagging. What do you want to bet that MS will spin this in 3 and 6 months as doing "better than expected"?

Microsoft definitely wants to be able to do so. However Microsoft even more would like to be able to beat expectations, and they're not.

It used to be that Microsoft beat expectations because they really beat expectations. Then for several years now they've played financial games to move earnings and investments around so that they can still officially beat expectations even though they are no longer growing like they were. The market noticed the change and their stock has held constant. But now they've run out of the ability to do that. The market noticed and Microsoft's stock price dropped. :-)

Either that or these analysts seem to be seeing things that aren't covered in the story. Hmm.

The reporter is quoting analysts commenting on what has changed. The reporter doesn't understand the background that analysts are assuming in their analysis, and hasn't reported on that.

Cheers,
Ben