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Microsoft Takes the Long View

Updated from 5:27 p.m. EDT

Microsoft (MSFT) has decided to forgo profitability in favor of heavy investments in its video-game business, online advertising and other areas the company deems high growth.

But investors appeared leery of the new strategy and quickly pushed the stock down $1.75, or 6.4%, to $25.50 in after-hours trading Thursday on Instinet.

The "strategic decision," as CFO Chris Liddell calls it, explains the company's surprisingly weak bottom-line performance in the just-completed third quarter and the disappointing earnings guidance for the fourth quarter and fiscal 2007.

Late Thursday, Microsoft announced that it had earned $2.98 billion, or 31 cents a share, (excluding a legal charge of 3 cents a share) on sales of $10.9 billion.

Although that represented year-over-year revenue growth of 13% and earnings growth of 17%, it fell short of Wall Street's expectations. Analysts were looking for $11 billion on the top line and 34 cents a share on the bottom line.

The sudden bout of bottom-line blues surprised Microsoft bulls and gave skeptics like Pat Adams, chief investment officer of Choice Investment Management, more reason to stay away. "There's just no reason to be in this stock until new products ship," he says.

Microsoft, the world's largest software maker, attributed the miss to heavy spending in a number of areas, including the Xbox 360 product costs, accelerated hiring, more R&D and heavy marketing, as the company prepares for the launch of Vista, the new version of its flagship Windows operating system.

"We're willing to make those tradeoffs for growth," Liddell said during a conference call with analysts.

Surprising as the third-quarter miss was, the weak earnings guidance was simply stunning. "I'm blown away," commented Richard Williams, chief software analyst for ICAP.

EPS in the June, or fourth quarter, will be about 30 cents, the company said, compared to expectations of 34 cents. Revenue will range from $11.5 billion to $11.7 billion, the company said; Wall Street was looking for $11.6 billion.

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