MSFT and the missing $2.4 billion dollars

So earlier this week, Microsoft announced earnings and expectations for the coming fiscal year. There seems to be a lot of buzz about this $2.4 billion dollar spending that’s planned. Here’s a related snippet:

Microsoft’s Coming Revenue Trade-off

For fiscal 2007, starting July 1, 2006, the company expects revenue in the range of $49.5 billion to $50.5 billion; operating income between $18.7 billion and $19.3 billion and diluted earnings per share somewhere between $1.36 and $1.41.

Those numbers puzzled analysts. The consensus had been for earnings of $1.53 per share on revenue of $49.5 billion, and they wanted to know where that money was going.

[snip]

In her follow-up query, UBS Warburg analyst Heather Bellini said it appeared that over the next few years Microsoft would see accelerated revenue from launches but was willing to sacrifice earnings growth to reinvest in other projects.

Liddell would not comment beyond next year’s guidance but “clearly from our point of view, we’ve made a strategic decision relative to next year where we’re willing to make that trade off to get ahead and also in the third and fourth quarters as well. I don’t want to extrapolate to ‘08 or ‘09.”

This news worried Wall Street. In a research note published after the call, Sherlund wrote that the company’s spending outlook “is quite surprising.”

Obviously I don’t know where the $2.4 billion is going (though I do have some suggestions if we’re short on ideas!) but I’m going to assume that it is going into R&D. This isn’t exactly a leap of faith as that’s what a number of articles and blogs have speculated about.

Alas, Wall Street doesn’t like surprises or increased investment. Here’s what happened to Microsoft stock this week:

Youch.

Not terribly surprising though either - after all, there’s a general opinion that Wall Street tends to reward the stocks of companies that layoff employees. Spending = bad.

At the end of the day though, this reminds me of this portion of testimony to Congress by the President of the Johns Hopkins University:

Remarks by William R. Brody: Testimony to the House Committee on Science

Norm Augustine, now retired CEO of defense giant Lockheed Martin, told me that when he was the CEO of Martin Marietta, the precursor to Lockheed Martin, he one day called in the analysts to announce a series of investments in research that he felt would propel the company way ahead of its competition. Much to his surprise, as soon as he had finished his presentation, the analysts ran out of the room, sold the stock and the price plummeted — and continued to drop over the next 18 months. Puzzled about the negative reaction to this news, Norm asked one of the mutual fund analysts why the stock had dropped. He was told: “Everyone knows it takes 8 to 10 years for research to pay off. But our shareholders only hold stock less than one year. Our fund doesn’t invest in companies like yours that have this kind of management.”

The drumbeat of quarterly results are driving business decisions and drowning out long-term management, investment and innovation strategies. Today, investor patience is in short supply, and the traditional “buy and hold” approach to equity investments is being abandoned by the professionals. U.S. mutual funds are holding stocks for an average of just ten months, a record low, and annual turnover rates are 118 percent, a record high. As Norm Augustine discovered, these short investment horizons pressure CEOs to focus on near-term results. Not long ago, a survey of chief executives by Burson Marstellar found that their number one business priority was shareholder return. The category “Most Innovative” ranked eighth on the CEO’s list, and was a priority for only 23 percent of the respondents. Another survey of financial executives found that fully 78 percent would give up long-term value creation in the company in exchange for smooth earnings. More than half — 55 percent — said they would avoid long-term investments that might result in falling short of the current quarterly targets.

Admittedly, it will be difficult to change Wall Street’s attitudes and habits. But it is terribly important to this country that we begin to try to do so. We can use the tax code to reward the behavior of companies that make significant research investments and take significant risks, just as we can find disincentives to short-term, bottom-line-only thinking. In doing so, we will make holding stock of innovative companies over the long term a more desirable investment, and our national economy more competitive.

Perhaps Google’s policy of not providing guidance is the right one after all. What do you think?