Editor’s note: Allan Krans follows IBM as an analyst for Technology Business Research. His review is based on IBM’s third-quarter results that were announced Thursday after the markets closed.

Software remains bedrock in difficult times for IBM.

IBM (NYSE: IBM) software’s financial management and execution matches the positioning of the segment, which is to solve middleware and information management issues that allow customers to focus on their businesses, and partners to deliver their value proposition through applications.

Even with ample opportunity to dramatically expand the company’s software portfolio over the past five years, IBM remains focused on improving and broadening its expertise within the middleware segment. This strategy may not have produced the type of rapid growth that Microsoft and Oracle have generated, but it has resulted in a stable revenue base that is capable of carrying the company through difficult periods.

IBM software performed particularly well during the quarter, producing 12% revenue growth and increasing both gross and operating margin levels compared with the year-ago quarter.

Chief Financial Officer Mark Loughridge noted the performance in the software business was sustained by a large annuity business, which accounts for a majority of the company’s software revenue. Over the past five years, IBM Software’s revenue did not exceed 20% in any quarter, but the segment also did not report revenue declines of more than 5%. TBR believes the large annuity software business of IBM, and the segment’s focus on core software infrastructure that requires investment regardless of the economic environment will enable IBM Software to produce high single digit revenue growth through 2009.

Increasing focus on short-term strategic software deals

IBM software continues to produce strong revenue and profit growth, but the segment is experiencing changes in the nature of its business due to the worsening financial environment.

Loughridge reported during the 3Q08 earnings call that the focus of software investments during the quarter was primarily on projects delivering short-term returns, versus longer-range projects. In periods of economic decline, customers focus on maintaining the IT infrastructure already in place, and seeking out projects that produce immediate returns by increasing efficiency.

The IBM software portfolio is particularly well-suited to both these tasks, and the company noted an increase in demand for its virtualization technologies in both the Operating System and Tivoli software brands. This trend was also evident in Oracle’s 3Q08 earnings, as the company reported 26.7% growth in database and middleware revenue, while applications revenue growth fell to 8.9% following 15 quarters of strong double-digit growth.

Since the enterprise software sales cycle can range from 12 to 18 months, IBM maintains strong visibility into its future software growth, and at this point the pipeline appears positive. During its earnings call, Loughridge mentioned the Software sales pipeline is 8% higher compared with the prior year, which represents a strong base for 4Q08 and into 2009.

Balancing cost constraint with future investments

Even with the strong performance in 3Q08, and promising future revenue pipeline, IBM is cutting costs to better position its business for the new economic environment.

IBM Software increased its gross margin during 3Q08 by 50 basis points, and decreased its operating expenses by 60 basis points. The net result of IBM Software’s cost restraint, combined with revenue growth, was that operating income in the segment increased by 19%, and operating margin rose from 27.3% in 3Q07 to 29.1% during 3Q08.

While IBM Software is being more cognizant of its expense levels given the deteriorating economic environment, the company does not currently expect to cut its level of expenditures, and will continue to invest in sales and R&D initiatives. On the sale side, TBR expects IBM will continue to expand its partner support and sales presence in the SMB market, which is a key strategy for the company to achieve net new growth that expands the customer base.

And in R&D, IBM is expected to maintain its commitment to expanding cloud computing capabilities and developing next generation technologies like virtualization and SOA that will form the foundation for growth over the next ten years. TBR estimates indicate IBM Software increased its SG&A expenditures in 3Q08 by 9.6% compared with 3Q07, and that R&D spending rose by 8.9% during the quarter.

We anticipate spending growth will remain in the high single digits during the next year as IBM Software continues to invest in a number of growth initiatives to support its business over the next decade.