What Exactly Has Microsoft Delivered on Its Enormous R&D Investment?

A couple of weeks ago at the D7 Conference in Carlsbad, Calif., Microsoft (MSFT) CEO Steve Ballmer boasted the software company could create a lot of new things by spending $9.5 billion annually on research and development expenses. That's right, Microsoft spends almost $10 billion each year on R&D. That's more than any other company in the world, by a long shot.

R&D spending at many tech, pharmaceutical or biotech companies is treated as motherhood and apple pie. R&D is never a bad thing -- it's only good. More is always better. When you invest in research, you are investing in hope and possibilities. No matter how much you have lost in past projects that never panned out, every new dollar invested in a R&D project holds the possibility that it will deliver a large multiple of that dollar in future earnings before interest, taxes, depreciation and amortization.

Spending a lot on R&D would be a good thing for Microsoft if it was generating a large return from that investment. But that's not the case and it hasn't been the case for a long time. Ballmer's comments show that Microsoft's senior leadership is proud of its continued investment in R&D and sees it as a source of competitive advantage for the company. On an absolute dollar comparison basis, Microsoft is making a much bigger bet than most in this area.

Microsoft spent 46% more than the $6.5 billion IBM invested in R&D last year, 252% more than Oracle (ORCL) ($2.7 billion), 763% more than Apple (AAPL) ($1.1 billion), and 390% more than Google (GOOG) ($2.8 billion). Yet, most would conclude that Microsoft isn't 9 times as innovative as Apple, despite the discrepancy in how much money it is pouring into its research activities. Beyond its Office, Client, and Server core franchises, it's difficult to name innovations associated with Microsoft.

What is also remarkable about Microsoft's spending on R&D is the cumulative total racked up over the years. In the last 10 years, Microsoft has invested $62 billion in the R&D area. Microsoft could have bought back nearly 40% of its stock with that amount; it could have beefed up its dividend; it could have made a string of acquisitions which presumably would have continued to grow its top and bottom lines more than what it has achieved organically.

It's hard to know exactly what Microsoft has delivered for its R&D investment; it doesn't break out the numbers according to its five business segments. However, the two smallest business segments -- Entertainment & Devices, which includes the Xbox, Zune, and Windows Mobile software groups, and Online Services, which includes Search, and the Microsoft MSN, Hotmail, and Messenger properties - likely have taken the lion's share of the investment. Combined, these two divisions have delivered $71 billion in revenue for Microsoft over those 10 years and $15 billion in losses.

So, what Microsoft's $62 billion R&D investment has led to is a $15 billion loss for at least those two businesses in 10 years.

Ballmer has argued that Wall Street investors are too focused on the short-term. One large Microsoft investor told me recently that Ballmer had complained loudly to him about the short-sightedness of investors who called on the company four years ago to do a large stock buyback and pay out a dividend with the excess cash on Microsoft's pristine balance sheet.

Ballmer apparently said to this large investor: "We did everything they asked for. We did a huge buyback. We did the biggest one-time dividend ever. And what good did it do us?"

Ballmer's right. Total shareholder returns, or TSR, for Microsoft since it initiated its stock buyback and dividend program are down 25%. For the last 10 years, TSRs fell 47% (as of early April). This includes returns from dividend payments (including the big, one-time dividend of $3 a share), as well as stock appreciation, over that time.

Is 10 years a sufficient amount of time for a shareholder to wait to judge a company's management team for how it has performed? Those TSR numbers are clearly unacceptable and likely reflect poor investment decisions and loss of confidence by shareholders in the future prospects for the company.

Over that same 10-year time period (again, as of early April), Apple's total shareholder returns have been 826%, Nintendo's (NTDOY.PK) have been 243%, Oracle's have been 166%, IBM's have been 3%, and Nasdaq's returns have fallen 37% -- all substantially higher than Microsoft's TSRs.

If the predominant Microsoft strategy of investing more in internal R&D, steering away from acquisitions, and keeping tight control of the five business segments has led to these results in the last 10 years, should shareholders expect that the same approach will lead to different results in the next 10 years? Are we being "short-termists" or "flippers" of the stock by pointing out these results and suggesting they should have been much better?

R&D spending can lead to blockbuster returns. And Microsoft has a big advantage relative to its competitors in that it can invest enormous sums for future product development. But Microsoft, in being proud of the fact that it can spend almost $10 billion a year on R&D, is like a driller of oil and gas being proud of the fact that it can drill thousands of dry holes. It doesn't matter what you spend on R&D; it only matters what return you make from that investment for your investors. So far, Microsoft hasn't delivered on its promises.

A private-equity investor friend of mine once told me that he only liked investing in companies who practiced "small 'r' and large 'D' R&D" - meaning he wanted to see fewer ivory tower white coats and more of an emphasis on taking cutting-edge ideas and technologies out of the lab and building a real product and revenue stream around it. That process requires discipline, but it can be managed.

Microsoft isn't the first large company to face this challenge of effectively managing its R&D process. Hewlett-Packard (HPQ) lost its way a few years ago. Pfizer (PFE) and other "big pharma" companies are facing similar questions around their R&D activities.

Instead of patting Microsoft on the back for its continued spending on R&D, investors and the press should be asking, "Where's the beef?" The onus should be on the company's management to articulate why its status quo approach for running this function will lead to different results in the next 10 years. Otherwise, I can think of several better ways to spend the next $62 billion of cash flow.

Disclosure: At the time of publication, Jackson's fund held a long position in Microsoft.

Comments

[Leftfield:]

Microsoft has been all about taking ideas of others and either buying them or copying then clobbering them in unlevel "competition" from the perch of their overwhelming installed base (Netscape). They are as innovative as GM (which long boasted healthy R&D).
At least they are far from needing a bailout but their stubborn refusal to capitalize on their R&D advantage shows a serious systemic problem. GM did the same and the world passed them by despite their overwhelming advantages .
Unfortunately, government is the very worst and recognizes it's own image in large failures with legacy prestige and clout. They are taking on advanced systemic failures and throwing in all that remains of America's balance sheet.
Go into an Apple store and see desirable products sold intelligently that entice and persuade, not coerce or fool, customers to see benefits in a purchase. Most American businesses are MBA-run standard issue predators looking for any loose dime they can find by any means. Where boards and management have no specific expertise or love for that business.
Our unparalleled payscale for our leaders has yielded empty pockets for Americans and festering problems everywhere. Microsoft is headed for Detroit. The U.S. is too.

Jun 11 07:00 AM

[William Mon...:]

I think the R&D hasn't done to bad, the XBox is proving its potential and will continue to grow, the link up with Murdochs Sky and Fox for content as well as netflix streaming films is a real boon. So with the Xbox you can now - play games, watch DVD's, watch streaming films, watch TV, listen to music. The 'beef' will come.

Bing is a good start and anyone that can provide competition to google is most welcome in the market place. There is plenty of 'beef' to be taken from google!

Windows 7, looks like the real deal finally. I am one of the 1M testers out there and its easy to use and stable for a beta. Most businesses didn't roll out Vista and stuck with XP (now an 8 year old OS). They will roll out Windows 7 - So much 'beef'!!!!

Other parts of the business have been developed in an adequate way, MSN, Hotmail, Office etc.

Failures Zune - bound to fail, Windows mobile - they were the first with a mobile operating system! How could they have lost to RIM, Apple, Android - spectacular failure!

Jun 11 07:06 AM

[David Van K...:]

Excellent article.

Anybody who's worked in a large corporation knows that when it comes to R&D, there is a wide spectrum running from money wasted on dumb ideas that were doomed from the start to dollars well-spent on projects that turn into blockbuster winners for the company. It's not that the company "stubbornly refuses to capitalize" on its R&D spending. It's about not being very good at identifying and developing the most promising ideas, and/or not knowing how to turn promising developments into commercial products.

Microsoft falls into both categories. Their core cash-cow businesses are now decades old. Much of their success has been based on marketing, not product innovation. Most product innovation has consisted of periodically updating existing systems and breathlessly introducing them. A couple decades back, it worked: People anxiously awaited the next version of Windows. But not any more.

I think the picture is simple: Microsoft is just not very good at R&D. They're like the Chicago Cubs, a terrific ongoing business but perpetually doomed when it comes to winning the big one. Other than integrating their web browser into their dominant OS (15 years ago), they've missed every significant large-scale opportunity to break into the web-centric computing world.

They would probably be better off if they scaled back their R&D spending. The resulting scarcer dollars might lead to the creation of a more effective R&D culture, one that becomes more innovative and effective because it has to. Plus that would free up more dollars for worthwhile uses, like increasing the dividend.

Jun 11 08:52 AM

[TinyTim:]

MS traditional business model is to copy ideas, then out-market the originator & benefit from their huge market share and captive audience. This has little R&D. In a software company, an overwhelming share of activity is "development". It's the equivalent of making widgets on an assy line. So the disproportinate share of R&D money may just be accounting terminology.

"Steve Ballmer boasted the software company could create a lot of new things by spending $9.5 billion annually on research and development expenses."
The operative word here is "could".

"Ballmer apparently said to this large investor: "We did everything they asked for. We did a huge buyback. We did the biggest one-time dividend ever. And what good did it do us?""
This is scary. Is Balmer competent?

MS is now a big bloated bureaucracy. If they spent part of this R&D money on researching software quality and development processes, they may put themselves in a position to excel.

A couple years ago, in a software class, the professor asked if anyone was considering buying Vista. The response was "we'll wait for Service Pack 2." This was renamed Windows 7

Jun 11 02:36 PM

[BioBoy:]

I wouldn't call "Office" a Microsoft innovation. The initial innovations were WordPerfect and Lotus 1-2-3. Microsoft simply knocked-off those programs and made minor improvements. The most recent versions of Office have introduced big changes, but they haven't been positive. In effort to make Word and Excel more user-friendly, Microsoft totally reworked the interface from efficient drop-down menus with keyboard shortcuts into tabs with icons. The major impact has been to anger and frustrate the core users of those programs. While they may be slightly easier for people who only use them rarely, it now takes frequent users 3x longer to issue commands. If this is "innovation" then I'd rather they spend $0 on R&D.

Jun 12 04:20 AM