Editor’s note: Allan Krans, a senior analyst with Technology Business Research, analyzes Microsoft’s Oct. 23 earnings report. Microsoft reported a 2-cent per share increase in profits (to 48 cents, or $4.29 billion) while revenues grew 9 percent to $15.06 billion from the same quarter in 2007.

HAMPTON, N.H. – Diversification brings its benefits for Microsoft (NYSE: MFST).

Although Microsoft continues to endure speculation and questions regarding its Online Services Business and Entertainment and Devices divisions, the company’s expansion efforts have positioned it to drive continued growth in spite of the worsening economic conditions.

Microsoft’s core Client and Business Division segments remain solid, profitable businesses, but controlling a majority of the market in these businesses leaves little shelter from a downturn in technology spending. Microsoft’s Client business, which includes the desktop Windows product family, is already showing weakness, reporting slim revenue growth of 1.9%, 4% lower than guidance, as the temporary effects of increased Vista premium mix waned and PC shipments fell below double-digit growth during the quarter.

Just as Microsoft’s Client and Office businesses benefitted directly when the PC market was on its way up, the company’s core businesses will be subject to the downward swings expected to occur over the next year.

Windows is the first casualty of the slowdown

As Microsoft’s Windows business fell short during the quarter, the Server & Tools and Online Services businesses both contributed to sustain corporate wide revenue growth during the quarter. Revenue in the Entertainment and Devices business declined 6% during 3Q08, due to a difficult comparison, but revenue was much stronger than Microsoft’s guidance, which predicted a 23% segment revenue decline. Microsoft’s expansion segments, including Server & Tools, Online Services, and Entertainment & Devices each required significant investment from the company, but are expected to deliver a net benefit to Microsoft in light of current economic conditions. Each of these segments possesses ample opportunity for Microsoft to grow and gain share, providing the opportunity to grow revenue even if the overall market enters a period of slow or no growth.

S&T, OSB, and E&D may not match Windows profitability, but play important strategic role

In addition to the financial benefits of Microsoft’s expansion segments, the Server & Tools, Online Services, and Entertainment & Devices segments each also provide some complimentary benefits to Microsoft’s core software strategy. With operating margins of above 60% in both the Client and Business Division, Microsoft will never be able to replicate that profitability in any of its expansion efforts.

The largest enterprise software vendors such as SAP and Oracle drive operating margins around 40%, and despite Google’s dominance in the online search markets, the company’s operating margin hovers around 25%. That does not mean that Microsoft’s online, entertainment, and enterprise software investments are in vain, however, as each segment contributes revenue and also serves a vital role in protecting the highly profitable core of Microsoft’s portfolio. The rise of Linux and open source tools threatens Microsoft’s position within enterprise software accounts, and Server & Tools portfolio expands the company’s presence, serving an important account preservation role. Microsoft also recognized the shift towards home digital entertainment and the increasingly important role of the Internet, and the Entertainment & Devices and Online Services Business represents Microsoft’s effort to keep its business out in front of these trends.

The direct profitability of these divisions may not be positive, but the indirect payoff is derived from their ability to protect and preserve Microsoft’s highly profitable businesses.

Proactive spending cutbacks planned to maintain margins

Despite the continued strength in Microsoft’s business, the company is acting now to mitigate the impact of a slowdown in IT spending. Over the past two years, Microsoft remained on an aggressive investment path, building out its data center facilities, expanding overseas presence, and adding headcount.

Following rapid increases in spending, Microsoft announced plans to reign in spending during the remainder of the fiscal year to keep expenses in line with lower annual revenue expectations. The company plans to begin with low-impact cutbacks, including a slowdown in hiring, and reduced travel and marketing. Microsoft also disclosed a planned slowdown in its datacenter build out, after opening more than $1 billion new facilities during 2008 thus far.

Though CFO Chris Liddell stated the company would evaluate deeper cutbacks if economic conditions warrant, TBR believes Microsoft’s spending control efforts will remain shallow, as the company’s core business will likely remain strong in spite of the downturn.