Editor’s note: Allan Krans is senior analyst for Technology Business Research.

Hampton, N.H. – Even stable Microsoft is not immune to the slowdown.

The severity of the current economic downturn was reinforced by Microsoft’s 4Q08 results, which fell short of both revenue and earnings per share expectations. Microsoft, which has never registered a year-to-year decline in quarterly revenue in the company’s history, came close to breaking that streak during 4Q08, reporting revenue growth of only 1.6 percent.

The earnings news led to Microsoft’s announcement of its first ever layoffs – some 5,000 job cuts.

The results reinforce that the current economic slowdown is unprecedented in modern history, as Microsoft has been a stable financial performer regardless of the economic environment. During the last major economic downturn in 2001, Microsoft emerged relatively unscathed, and continued to grow revenue, even as vendors such as IBM, HP, and EMC experienced prolonged and significant revenue declines.

Windows and Office Led the Slowdown

Microsoft’s diverse product and customer mix provides a good degree of insulation from quarterly fluctuations, but was not sufficient to overcome significant weakness in the company’s core Windows and Office businesses during 4Q08. Microsoft rode the Windows and Office businesses to new heights of revenue and profits over the past two years, but the downturn in customer spending quickly ended that trend in 4Q08.

Revenue in the Client division, which includes the Windows family of products, declined by 6 percent during 4Q08, and revenue growth in the Business Division, which includes Office, increased by 1.3 percent, while consumer revenue in the division declined by 23 percent. The weakness in Microsoft’s core businesses was driven by a perfect storm of scaled back consumer and business spending, flat PC shipments, declining premium SKU mix, and a greater mix of netbook and emerging market PC shipments.

The end result was flat PC shipments meant Microsoft had fewer opportunities to attach its desktop products, and the shift in units towards lower-end netbook and emerging market shipments meant the company received less revenue for each unit it was able to attach.

Profitability Was Harder Hit than Revenue

Even more than their contribution to overall revenue, Microsoft remains heavily dependent on Windows and Office for profitability. The 60 percent+ operating margins in the Client and Business Division segments have funded Microsoft’s expansion over the past five years, but that dependence could lead to strong pressure on the company’s bottom line if revenue continues to weaken. The Online Services Group registered an operating loss of 54.4 percent and the Entertainment & Devices segment produced a 4.7 percent operating profit during 4Q08, both significantly below the corporate wide operating margin of 35.7 percent. The shift in product mix away from high margin Client and MBS and towards lower-margin segments was already noticeable in 4Q08, as operating income declined by 8.4 percent during the quarter, even as revenue growth remained positive. Continued weakness in Client and Business Division revenues would have a pronounced effect on corporate wide operating margins, and perhaps force Microsoft to consider more dramatic cost reduction efforts over the next year.

Unprecedented Environment Elicits Unprecedented Responses

Facing what Chief Executive Officer Steve Ballmer termed an “unprecedented” economic environment, Microsoft in terms has announced unprecedented actions in response. Microsoft will reduce headcount by 5,000 over the next 18 months, marking the first corporate wide headcount reduction in company history. The company will also delay planned capital expenses, including postponing data center construction and facility expansions.

Microsoft expects the cost adjustments will reduce operating expenses by $1.5 billion annually, with an additional $700 million reduction being driven by the delayed capital expenditures. Compared with the scale of Microsoft’s operations, and in light of the severity of the economic environment, TBR believes the cuts announced today are quite modest. Microsoft’s annual operating expense cost base totals more than $27 billion, and its total headcount increased by 14 percent over the past year to a total of 97,000 at the end of 2008.

CEO Ballmer and CFO Chris Liddell further explained during the 4Q08 earnings call that any job cuts will likely be muted or even offset by job growth in strategic areas. We believe the headcount reduction announced today was a largely symbolic gesture to investors, analysts, and employees that Microsoft recognizes the severity of the current environment and is committed to taking at least some action to preserve profitability.

Opportunity to Rationalize the Business Portfolio?

Not according to Ballmer.

Microsoft’s large dependence on two segments for profitability took its toll during 4Q08. Particularly in the Online Services Group, questions will likely continue to be raised about the viability of the business, and whether Microsoft should consider a divestiture or sale or at least some of the search assets. In times of economic distress, it’s logical to review the overall portfolio and make tough decisions, just as Microsoft made the difficult decision to reduce headcount for the first time in its history.

When asked whether Microsoft would take this opportunity to review its portfolio for potential divestitures, Ballmer left a long period of silence, followed by the response that both he and the board were happy with their current portfolio. The company’s business results speak for themselves, however, as the Online Services Group ran through large sums of investment over the past three years with little in the way of returns. The segment produced operating losses in each quarter for the last three years, and the losses have accelerated recently, with more than 50 percent operating losses being reported in each of the past three quarters.

Microsoft’s cumulative operating losses in the Online Services Group totaled $3.1 billion over the past three year, with losses during calendar year 2008 totaling $1.6 billion. The shift towards cloud computing and SaaS will inevitably have an impact on Microsoft’s business, but the concerted focus on challenging Google in the search and advertising business should at least draw a second look in light of the current business climate.