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 It's a problem that hasn't gone away. Indeed, Microsoft's current
issues in China conceal a deeper problem for the U.S. software giant
- despite the popularity of its Windows operating system and Office
suite, few people in emerging markets are willing to pay for
legitimate copies.
This not only costs Microsoft in lost revenue, but is also holding
back the spread of its newest Windows 8 version - analysts say even
buyers of pirate software prefer older versions. According to
StatCounter, a website that tracks what software is loaded on
Internet-connected computers, more than 90 percent of PCs in China -
now the world's biggest market - are running pre-8 versions of
Windows.
Microsoft is trying to tackle this. This year it's offering Windows
8 at a discount to PC manufacturers who install its Bing search
engine as the default. And it's giving away versions of Windows 8
for phones and some tablets.
But, as the industry shifts from desktop to mobile, the cloud and
free or cheap software, China sums up both the old and new
challenges Microsoft faces in making money in emerging markets -
and, increasingly, in developed ones.
"The great danger for the company is that what has happened to them
in emerging markets - basically no revenue from new PCs because of
piracy - is not far off what's happening everywhere," said Ben
Thompson, the Taiwan-based author of stratechery.com, a popular
technology blog.
CORE COST
For sure, China is a major, and unique, headache for Microsoft. Many
of the problems are tied to a broader push by the Chinese government
to limit foreign firms' dominance and encourage local technology
firms to become viable competitors.
After years of healthy relations with Beijing, Microsoft last month
was suddenly targeted by anti-monopoly regulators who raided its
China offices as part of a price-fixing investigation.
But the spats mask the fact that Microsoft has never really cracked
how to get people in emerging markets to pay for its software. The
company rarely breaks out revenues by geography, but it has provided
clues about the size of the problem.
In 2011, then CEO Steve Ballmer reportedly told employees that,
because of piracy, Microsoft earned less revenue in China than in
the Netherlands - with 1 percent of its population - even though
China bought as many computers as the United States.
According to the BSA anti-piracy lobby group that Microsoft
co-founded, emerging markets account for 56 percent of all PCs in
use, and 73 percent of software piracy. Of the $77.8 billion revenue
Microsoft generated in its 2013 financial year, China, Brazil and
Russia each "exceeded" $1 billion, according to a Microsoft
presentation. For comparison, Apple Inc generated $27 billion in
Greater China, which includes Hong Kong and Taiwan, in its 2013
financial year.
For Microsoft, that's a lot of lost revenue from the heart of its
business. "Windows and Office are still very much the core of
Microsoft," says Sameer Singh, an India-based analyst.
The most recent breakdown by Microsoft of its results by product
line - for the first quarter of fiscal 2014 - shows that 56 percent
of its global revenue and 78 percent of operating profit came from
Windows and Office.
Microsoft doesn't just lose the revenue from pirate copies, it also
loses access to customers who might buy other Microsoft products
that work with or on top of Windows and Office.
Across most markets, Windows and Office account for more than half
of revenues, says Andrew Pickup, Microsoft's Asia PR chief. This,
analysts say, is because many of Microsoft's other products, such as
Exchange and Windows servers, depend on customers already using
Windows and Office.
"The Microsoft ecosystem is obviously pretty interconnected," says
Jan Dawson of U.S.-based Jackdaw Research. "So it makes sense that
the proportion of revenue would be similar in emerging markets."
NAKED PCS
Part of the intractability of piracy in emerging markets is that
each part of the chain poses a problem.
For PC makers working on wafer-thin margins the operating system is
one of the costliest parts of the machine, while mom-and-pop shops
which form the bulk of retailers in such markets can't afford to
turn away price-sensitive customers who are comfortable buying
pirate software.
The problem, therefore, starts with computer makers, Singh says,
since "convincing them to ship every PC with Windows pre-installed
is difficult." Margins on PCs for a company like Lenovo Group Ltd
are "near single digits," says Bryan Wang, an analyst at Gartner.
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The result is that up to 60 percent of PCs shipped in the emerging
markets of Asia, says IDC research manager Handoko Andi, have no
Windows operating system pre-installed - so-called 'naked PCs',
which usually instead carry some free, open source operating system
like Linux. That compares with about 25 percent in the region's
developed markets like Japan and Australia.
A quick scan of Taobao, the popular Chinese e-commerce site operated
by Alibaba, shows a vast selection of PCs shipped with Linux rather
than Windows. Once the machines hit the retailers, it's hard to tell
where legitimate software stops and piracy begins.
On a recent morning in Zhongguancun, a teeming electronics hub in
north Beijing, shopkeepers offered to bundle what they said were
legitimate versions of Windows with a new laptop, either for free or
the equivalent of about $30.
Microsoft began lobbying Lenovo in 2004 to stop shipping naked PCs,
but the Chinese firm countered that its margins were too low, a
person familiar with the negotiations said. Two years later - just
days before then-President Hu Jintao visited Gates' U.S. home -
China announced a new law requiring PCs to be shipped with operating
systems. That merely dented piracy rates, which fell to 79 percent
in 2009 from 92 percent in 2004, according to the BSA.
Lenovo said it reached an agreement with Microsoft in June of this
year to ensure that Lenovo PCs sold in China would come
pre-installed with a genuine Windows operating system.
"MOBILE ALSO-RAN"
Microsoft's new approach is to push the price of Windows low enough
to make it worth a PC maker's while. The cost of a Windows license
has fallen to below $50 from as high as $150, said IDC's Andi,
taking Microsoft down to "levels where they've never competed
before."
Microsoft's Pickup said it was too early to gauge take-up.
In any case, making Windows cheaper for PCs is just part of a
broader response to deeper shifts in the industry. The rise of
mobile, tablets, cloud-based services and free operating systems has
marginalized Microsoft and challenged its business model.
While Windows is on more than 90 percent of traditional computers -
according to data compiled by analyst Ben Bajarin - that figure
drops to below 14 percent once mobile devices such as phones and
tablets are factored in, estimates Gartner.
More than half those devices run Google's Android mobile OS, which
is effectively free to handset and tablet makers. Apple, a key
player in all types of devices, gives away upgrades to its operating
systems for free.
Pickup says Microsoft has listened to phone makers' complaints and
relaxed what hardware they need to install the mobile version of
Windows. It has also made the operating system free on any mobile
device of 9 inches or less.
Taken together, the moves are "about bringing down the cost as more
and more of the populations in these emerging markets are having
their first computing experience," Pickup said.
These are significant concessions, analysts say, but Microsoft will
have to learn to be a bit player, where its software and services
run on other people's operating systems.
"The biggest threat to Microsoft," Dawson said, "is the shift from a
PC-based world where Microsoft dominated to a mobile world where
Microsoft is an also-ran."
(Additional reporting by Noel Randewich in SAN FRANCISCO and Bill
Rigby in SEATTLE; Editing by Ian Geoghegan)
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