Microsoft Tops IBM And Oracle On R&D Spending -- Combined

Microsoft CEO Steve Ballmer says his company will spend $9.5 billion on R&D this year. That's almost 50% more than IBM's $6.5 billion, and it's more than the combined R&D spending of IBM and either Oracle ($2.7 billion) or Google ($2.8 billion). And almost nine times as much as Apple's $1.1 billion. Is Microsoft deriving equivalent multiples in business value?Microsoft says the answer is yes, and extols its world-leading R&D budget in the "Shareholder Letter" in its 2008 Annual Report, which says the following in a section titled, "Transformation Through Innovation":

"At the heart of our success lies our commitment to innovation. No company in our industry invests more in research and development or has the same depth and breadth of talented researchers, scientists, and engineers working across the globe to create new technology breakthroughs. In 2008, we invested $8.2 billion in research and development, an increase of almost 15 percent compared with fiscal 2007."

But an investment manager who holds a long position in Microsoft says its R&D spending is out of control - he believes Microsoft needs to vigorously reassess its R&D philosophy, cut back on spending, and demand greater ROI from its R&D.

"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," writes investment manager Eric Jackson on Seeking Alpha.

In a provocative investment-side analysis of the R&D situation at Microsoft - and remember, Jackson is writing as an investor with a strong and very direct financial interest in the company's share price - he poses some tough questions about R&D that would be relevant at any time but are particularly so during today's troubled economic times that are accelerating the evolution - and sometimes the collapse - of a range of business models.

Noting that Microsoft in the past 10 years has invested $62 billion in R&D, Jackson says, "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."

Jackson then exercises his right as an investment manager to do a little speculating to try to see inside the numbers: "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."

And then Jackson, in what is otherwise an intelligently reasoned piece, gets way too caught up in his own speculative somersaults and comes up with this baseless doozie: "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." Like I said, remember his one and only POV on R&D is ROI.

But a short time later Jackson has regained his intelligent grounding and offers a compelling analogy:

"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."

Again, Ballmer and Microsoft would no doubt beg to differ, and here's another excerpt from that 2008 Annual Report about the impact its R&D has had on the company's products and processes:

"We launched Microsoft Windows Server 2008 and Microsoft Visual Studio 2008. We released Windows Vista Service Pack 1 and introduced advances in our search and online advertising technologies. We rolled out Surface-a groundbreaking new device that transforms a tabletop into a computing surface that enables people to interact with digital content using gestures, touch, and physical objects-in a number of retail and hotel locations. We unveiled new products and services for the healthcare industry. We announced important changes to our technology and business practices to increase the openness of our products and drive greater interoperability and choice for developers, partners, customers, and competitors."

A large portion of that Shareholder Letter is devoted to Microsoft's sprawling R&D operations and commitments, with the company saying it opened four research or development centers in 2008 while investing heavily in many new technologies.

So there's no question that Microsoft is making massive and even unprecedented investments in people, products, facilities, technologies, novel approaches, new collaborations, and other facets of R&D - no one could convincingly dispute that. But it would be revealing for the company to offer some tangible financial links between those staggering R&D investments and the financial payoff of customer acceptance in the marketplace.

As Jackson says in his closing comment, "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."