REDMOND, Wash. -- ( TheStreet) -- Microsoft's ( MSFT) disappointing quarterly results raise the question of why it hasn't used its ample cash reserves to buy faster-growing companies in a manner similar to its larger rivals IBM ( IBM) and Oracle ( ORCL). Last week's earnings results sent the software giant's shares tumbling 10% Friday. The biggest reason for the drop was the $1 billion shortfall in revenues which surprised analysts. Microsoft's operating results clearly do not mirror those of Google ( GOOG) or Yahoo! ( YHOO) in the search market (both had weaker results) and they do not mirror IBM's surprising upside results in the services market. Despite its five business segments, Microsoft's fortunes (and its stock price) most closely rise and fall with the fortunes of the PC market. As that market continues to struggle in the recession and while many customers wait for the rollout of Microsoft's Windows 7 in October and Office 10 next year, Microsoft experienced a strong pull-back in orders in the quarter and the first ever 12-month decline in revenues.
Microsoft bulls argue that the latest results look backwards, and the stock's price is going to reflect investors looking forward to the new product releases being rolled out starting in October with Windows 7. They say that the stock is already heavily discounted relative to its peers, even though its runup is more than 50% since its March lows. That leaves ample room for the stock to move up further. I agree with this view. Microsoft has a bigger problem, even with the coming product releases. The company's revenue stream is thinning, and it takes a lot of new revenue to keep this elephant looking like it's still dancing and deserving a higher P/E multiple. Although search engine Bing's successful rollout and a potential deal with Yahoo! are important bricks for Microsoft, their revenue impact to the company will still be very small for a long time. Even with the new products coming on stream, the market will be asking, "What's next?"
The simple truth is that Microsoft has to make acquisitions -- big ones -- to move the needle with respect to its overall top-line revenues and earnings. Unlike many of its competitors, Microsoft has the financial flexibility to do a few very large acquisitions and many small to medium-sized ones. IBM, Cisco ( CSCO) and Oracle have shown that they can successfully use an acquisition to grow top- and bottom-lines without getting overly distracted by the integration process. Some big-name acquisition targets for Microsoft, including SAP ( SAP) and Research In Motion ( RIMM), already have been thrown around by observers. Either would make sense, although SAP appears to be facing challenges of its own in growing its revenue. However, in talking with many Microsoft investors over the last few months about this strategy, I was surprised to hear such a high degree of skepticism about the company's ability to execute it. "Right strategy, wrong management," was a common refrain. Microsoft has made few acquisitions in its history -- and certainly not any on the scale of an SAP or a RIMM. When it has made acquisitions or large investments (like aQuantive or Facebook), the general perception is that it's done so quickly out of fear and have overpaid. At IBM, Cisco, or Oracle, they have SWAT teams of people with years of experience knowing which companies to go after and which to pass on. When they decide to engage in M&A discussions, they know exactly what that business is worth to them and can push back from the table when the bidding gets too rich.
Once a deal is struck, those companies know exactly how to get the business integrated into the fold, retain key executives and maximize the value of the deal for themselves in the long run. Microsoft has less of a successful track record in all these areas. The company might still be able to pull it off, but what kind of pilot would you like landing your jumbo jet: one with thousands of miles flown or a newbie? Given Microsoft's size, cash and low price-earnings ratio (which I believe reflects the market's concern about its future growth prospects), an acquisition strategy is the right one for the company -- as opposed to more internal investments in R&D, which already clock in at just under $10 billion a year. Investors' concerns about management's ability to execute are legitimate, but can be addressed. Executives can be hired from other companies who have a demonstrated track record of executing the kinds of acquisitions Microsoft needs. One hire will not do. Microsoft will need teams of people. Microsoft will also have to give these new people a mandate and then work with them to achieve it. That will require support from the board, Steve Ballmer, Chris Liddell and the heads of the five business segments (where the newly acquired companies will be integrated into), as well as key managers within those segments. Going from doing no real acquisitions to buying a company the size of an SAP would be a shock to the Microsoft system. It would be the equivalent to jumping on a moving subway train as it goes past your station. There is risk for investors. However, the question that needs to be posed to Steve Ballmer and the board by investors is, "What is your strategy to grow the business and the stock price if it does not include growth through acquisition and why is it likely to be more successful?" As an investor in the company, I would like to hear more discussion from Microsoft of the long-term direction of the company and less about Bing, Yahoo! and Google. -- Reported by Eric Jackson in Naples, Fla.