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Angry shareholders say Microsoft squanders billions on pointless R&D projects

Welcome to the second article in a series on Microsoft shareholder activism. These posts examine why investors, through the power of the stock price, aren't buying the idea that Microsoft has a great future.  In this post, one of the top Microsoft securities analysts weighs in, Brendan Barnicle from Pacific Crest Securities. (To summarize his take, "Yeah a lot of people are frustrated … the stock should have grown."). We reveal more details on what activist Craig Montgomery wants Microsoft to change. We'll give you a sneak peek of the third post in the series, a candid interview with an outspoken shareholder who likens Steve Ballmer and Bill Gates to fraudster Bernard Madoff.

When we last left off, we had explained Montgomery's viewpoint that Microsoft's lagging share price was not a result of the soft economy. Montgomery of The Crandrea Group is creating a grassroots shareholder activism movement. He thinks – and others interviewed for this story agree – that Microsoft's stock is underperforming and has been for years. One of the biggest problems, Montgomery says, is the astronomical amount of money that Microsoft spends on R&D. Not that he wants Microsoft to stop all R&D spending, but he, like the other investors we talked to, want an R&D reality check. By trimming the now-nearly $8 billion annually R&D budget, it is their belief that Microsoft frees up cash to do something truly game changing – like purchasing a mobile carrier.

"During 2007, Apple spent $782 million on R&D, Oracle spent $85 million while Microsoft spent about $7.5 billion. In 2007, Apple annual revenue amounted to $24 billion and net income totaled $3.5 billion," says Montgomery. "According to 2008 annual report, Apple increased revenue to $32 billion and net income to $4.8 billion. During the same period Microsoft spent $8 billion on R&D and increased revenue from $51 billion to $60 billion. Therefore, Apple has a R&D budget that equates to approximately 10% of Microsoft’s; however, during this period Apple increased revenue by $8 billion and Microsoft increased revenue by $9 billion."

Some of these billions have gone to Windows Live (and other cloud computing initiatives) and MSN. This should make sense. As software moves from the fat desktop to the cloud, it moves from software licenses to a subscription (which few are willing to pay) and advertising-supported freeware. Ergo, Microsoft needs to create a healthy cloud/advertising/search business

Problem is, activists say that what Microsoft has been doing isn't paying off.

Montgomery notes that Google has spent about $1 billion annually on R&D in '05 and '06, increasing to $2 billion in '07.  Meanwhile, in '05 its online advertising revenue was about $6 billion. In '07 that rose to $16 billion while its market share moved from about 30% to today's range of over 50%. He contrasts that to, in 2005, Microsoft generating online advertising revenue of $1.5 billion (compared with Google's $6 billion), reporting a mere 8% market share. In 2007, Microsoft reported revenue of $2 billion, which it says represents an even tinier 6% of the market.

"Google within this period has increased revenue by $10 billion and increased market share by 20%. Despite a larger R&D budget, however, within the same period, Microsoft has increased revenue by $500 million and potentially has lost 2% market share," Montgomery spells out.

So, then, if you can't develop your own home grown, you can always buy your way into a potential market with brilliant futures, right?. Wrong again, for Microsoft, says Montgomery.

It has bought Motionbridge, Medstory, Jellyfish, Fast Search and Transfer (that one for over  1 billion) and paid an astronomical sum of $6 billion for aQuantive. Then there's investments like Onfolio, bought in 2006, which was integrated into the Windows Live toolbar "and by 2008, Microsoft announced that this was discontinued," Montgomery recounts.

"Microsoft needs to stop telling the consumer what it wants and start asking what the customer wants. It is very ironic and yet a very sad commentary that Microsoft is a company that sells CRM software to clients (Microsoft Dynamics CRM)," he says.

While Montgomery would like to see Microsoft strike a deal with Yahoo on search – which would give Microsoft an instant about 30% market share in advertising -- he knows that if the company doesn't understand how to aptly serve advertisers, then it would simply be wasting more money.

In agreement is shareholder Mike McDonald. McDonald owns 118,000 shares of Microsoft, bought in 2000 at an average price of $36 share (adjusted for splits and dividend payouts). He has since seen the company grow its revenue and profits while his equity has been halved. And he's ticked about it.

"I still hold Microsoft so I still hold hope it will achieve what I think is its potential. By now it should have been $100+ per share. We've seen Apple rise and I remember when MS was handing out Apple oxygen because we didn't know if it would survive. (Funny. I don't even use Windows … I love the Mac.) I also believe Bill Gates is a charlatan because what he has said, implied, promised to shareholders and stakeholders and all of these visionary things that he mumbles and jumbles about and doesn't make reality of. MS is spending billions of dollars on R&D.  Where is the return on investment? Who is there saying, as IBM eventually did, 'We need to get a return on our R&D, we're a  business'?"

One big part of the solution, in Montgomery's eyes, is for Microsoft to buy a mobile provider – and not simply to partner with one, as it did with Verizon last month. He notes the math (per Citi analyst Mark Mahaney) that says Microsoft's recent deal to provide search to Verizon mobile users won't be a winner for Microsoft, as it will require each user to conduct 17 searches per month on their phones in the next five years just to break even.

He wants Microsoft to leverage its R&D money to buy a mobile carrier – in his mind, the perfect one would be the beleaguered Sprint, with $40 billion in revenue, 40 million mobile subscribers and trading at about $3 per share (at that rate, a market valuation of $7 billion).

McDonald agrees that a mobile acquisition would be good for Microsoft – though thinks Research in Motion is a better fit. Pacific Crest Securities' Barnicle isn't gung-ho on either idea. "As for buying a mobile carrier like Sprint, we just saw Microsoft divest itself in cable, its Comcast investment. It didn't work out. They didn't lose much money on that, but it's a similar principle to own its own mobile network so it can then control it … Buying something like Sprint is not something the shareholders would be happy about ... it would send the stock lower."

He doesn't see investors wanting Microsoft to buy into any business that the company doesn't know how to run, and when it comes to wireless, operating margins are deterorating even faster than on Windows products.

Barnicle says that Microsoft's main problem is an image battered by Vista. "There's the perception that Vista wasn't a successful product launch but it's been fairly successful from a financial standpoint. There have been mounting concerns all decade that Microsoft's business is going to be hurt from open source and that has never materialized, hurt from Google's Web Office application offerings, from open source versions of Office and those things never materialized," he said. "Microsoft has made its numbers. If you look at the Discounted Cash Flow (DCF) analysis, the stock price is suggesting that cash flow is going to decline at 3% a year in perpetuity and that's not going to happen."

Barnicle believes that the stock is also suffering from a nostalgia effect -- people remembering its glorious reputation in the 1990s and think it can't grow like that again. "It was a huge growth stock in the 1990s and it has experienced multiple compressions year over year. …Yeah a lot of people are frustrated … the stock should have grown -- if you look objectively at the numbers Microsoft has put up the last couple of years. In 2008 it grew revenue 18% and earnings 21%, it is expected to grow revenues at 2% in 2009, which is good in this economy, and earnings per share is down maybe 6% which is pretty stable. Plus, given its enormous cash position, [the stock is definitely underperforming]."

But McDonald says the numbers don't lie and investors are not fooled. Microsoft is losing market share on its high-margin products. Barnicle confirms this, "As for declining net operating revenues, that's part [of the reason the stock has underperformed]. Also declining margins. Investors are also frustrated with Microsoft's investments in its online business and entertainment devices."

In the company's defense, he says management is listening to its shareholders and doing what they ask of it. "There are lots of activist shareholders – and these are big, institutional investors. So you see management doing things like the Dutch auction [on a $20 billion buyback of shares in 2006], increased dividends, increased buybacks. They've done all the things investors have asked for and the stock is still underperforming. Shareholders are frustrated and management is frustrated."

Shareholders also aren't buying it. Stay tuned for the next installment where we will explore McDonald's guest blog entitled "How to screw up a monopoly."

Also see part 1 in the series Shareholder activist targets Microsoft

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