April 28 (Bloomberg) -- Microsoft Corp. shares had their biggest drop in more than five years after the world's largest software maker said it will increase spending on its Internet unit to stem customer defections to Google Inc.

The stock tumbled 11 percent on the most volume ever for Microsoft, erasing $31.6 billion in market value. At least five analysts, including Morgan Stanley's Mary Meeker, cut their ratings after the forecast, issued yesterday with the Redmond, Washington-based company's third-quarter earnings.

The spending surprised analysts, who said Chief Executive Officer Steve Ballmer may be investing too much at the expense of profit. Ballmer's decision to pour money into his MSN Internet unit probably will lead to an 18 percent increase in costs, to $22.3 billion in 2007, said Goldman, Sachs & Co.'s Rick Sherlund. Sales may rise 14 percent over the same period.

``I am disappointed,'' said Matt Kelmon, who helps manage $225 million at Kelmoore Investment Co. in Palo Alto, California. He sold about 40 percent of the firm's Microsoft shares in the three months ended Dec. 31. ``It looks like they are doing a lot more spending than expected.''

Profit will be $1.36 to $1.41 a share in the year beginning July 1, missing the $1.53 average of 30 analysts' estimates in a Thomson Financial survey.

In the fourth quarter, profit will be 30 cents a share on sales of $11.5 billion to $11.7 billion, Microsoft said. Analysts surveyed by Thomson on average expected 34 cents in profit.

Record Volume

Microsoft fell $3.10 to $24.15 at 4 p.m. New York time in Nasdaq Stock Market composite trading, the biggest decline since November 2000, when the shares sank on investor concerns over weak holiday sales of personal computers. Volume of 591 million shares was the most ever and nine times Microsoft's daily average over the past year. A trade as low as $23.60 was canceled.

The stock, which trailed the Standard & Poor's 500 Index the past three years, has lost 7.6 percent in 2006.

The forecast ``snuffed hopes'' of an expansion in profit margins next fiscal year, Meeker wrote today as she cut her rating to ``equal weight.'' Credit Suisse's Jason Maynard said Microsoft ``dropped an EPS bomb on investors'' and cut his estimate for the share price to $27 from $29.

``We're not that bad in forecasting expenses,'' Sherlund, the top-ranked software analyst by Institutional Investor magazine, said on the conference call yesterday. ``It sounds like you are building a Google or a Yahoo inside this company.''

Sherlund previously expected $20.6 billion in 2007 spending. He expects $18.9 billion this year, and in 2005 operating costs were $16.9 billion.

Chasing Google

Ballmer, 50, is seeking to accelerate sales growth after revenue had increased less than 10 percent in each of the previous five quarters. He is building up MSN to tap the soaring demand for Internet advertising that propelled sales at Google and Yahoo! Inc., which rank first and second in Internet search.

Chairman Bill Gates and Chief Technology Officer Ray Ozzie are spearheading investments into Web-based services as customers avoid aging versions of Microsoft's Windows and Office. Updates have been delayed to January, and revenue from Windows for PCs rose just 7.5 percent last quarter.

The company yesterday said third-quarter profit rose 16 percent on orders for database programs. Net income increased to $3 billion, or 29 cents a share. Sales in the quarter ended March 31 rose 13 percent to $10.9 billion, less than analysts expected.

Microsoft spent more to get Xbox consoles into stores after an initial shortage following their November release. Marketing costs also rose. Operating expenses rose 11 percent to $7.01 billion in the quarter compared with a decline of 20 percent a year earlier.

More Hiring

Now expenses will rise further. Higher-than-expected Xbox costs will continue in the fourth quarter, Chief Financial Officer Christopher Liddell said in an interview. Ballmer also has decided to invest in hiring and research and development in several areas that have potential for future growth at the expense of next year's earnings, Liddell said.

Beginning this quarter, Microsoft is raising investment in its MSN Web unit in a bid to catch Google, which is taking market share in areas such as search and maps. Microsoft is shelling out more for research into communications, business intelligence, security, high-performance computing and services, Liddell said.

``Whilst there is some short-term pain associated with some of the investments, we hope investors will give us some credit for taking a proactive approach to some of these opportunities,'' Liddell said.

Some investors said they don't have that kind of patience.

``The investment seems smart, but for the payoff I need to get a little bit closer to it,'' said Robert Mattson, an analyst at Gartmore Global Investments in Philadelphia. The firm manages $89.7 billion. ``There's nothing coming up for six months. If there's nothing to get excited about, then who cares?''

To contact the reporter on this story: Dina Bass in Seattle at dbass2@bloomberg.net.

Last Updated: April 28, 2006 18:04 EDT