• by Gavin O'Malley  @mp_gavin, January 22, 2009

Issuing a surprise earnings report before the opening bell Thursday morning, Microsoft announced a drop in earnings for its fiscal second quarter, along with plans to lay off as many as 5,000 employees.

For the period ended Dec. 31, Microsoft reported net income of $4.17 billion, or 47 cents a share, compared with net income of $4.7 billion, or 50 cents a share, year-over-year.

Mixed with the bad news, however, was some good. Revenue increased to $16.6 billion from $16.4 billion last year.

"Also, some people are overlooking the fact that online ad revenue went up 7%, so that paints a better picture than the ad services numbers," said Greg Sterling, principal analyst at Sterling Market Intelligence.

Over the next 18 months, job cuts will impact many areas of the company, including research and development, marketing, sales, finance, legal, human resources, and IT. The company eliminated 1,400 jobs on Thursday, according to Microsoft.

The cuts are expected to reduce the company's annual operating expense run rate by approximately $1.5 billion, and reduce fiscal year 2009 capital expenditures by $700 million.

During an earnings call Thursday, Microsoft CEO Steve Ballmer said he intends to bolster the company's search business with additional hires.

"Even as we take out 5,000 jobs, we will also add a few thousand jobs back into areas like search where we continue to see incredible opportunity to do good work," Ballmer said.

In addition, Ballmer said Microsoft was still open to a search partnership with rival--and one-time acquisition target--Yahoo.

According to Sterling, however, Microsoft does not have much of a choice. "They have to continue to spend money in the online area to stay competitive, particularly against Google," Sterling said.

Citing the highly uncertain economy, Microsoft refrained from giving a forecast for the current period.

"We are planning for economic uncertainty to continue through the remainder of the fiscal year, almost certainly leading to lower revenue and earnings for the second half relative to the previous year," said Chris Liddell, Microsoft's chief financial officer. "In this environment, we will focus on outperforming our competitors and addressing our cost structure."

Due to slowing PC sales, Microsoft's client business, including its Windows operating system, saw revenue fall 8% year over year. The business division, including its Office software, saw revenue increase by just 1% for the period.

Thanks to strong holiday sales of Microsoft Xbox 306 video game console, its entertainment and device business--which also includes the Zune music player--saw sales rise 3%. Price cuts, however, hurt the division's operating income, which fell 60% during the quarter.