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I was recently interviewed by Marketplace on National Public Radio [NPR] about internet buzz in China and how word of mouth often leads to a proliferation of pirated DVDs and CDs that are downloadable on the internet for TV shows like Prison Break (NASDAQ:NWS). A senior executive with Time Warner was also interviewed to highlight their efforts in combating piracy. You can hear the interview and read the transcript here.

Intellectual property rights have certainly been a hot topic on the agenda for President Bush and his predecessors like Clinton as the money lost by large MNCs like Nike (NYSE:NKE) and Microsoft (NASDAQ:MSFT) could go a long way to reducing the current trade imbalance between the US and China. The Business Software Alliance estimates that in 2005, 86% of all software used in China was pirated, accounting for a $3.9 billion dollar sales loss. On a recent trip to a local IT bazaar, several of my firm’s analysts found beta versions of Windows Vista in English for a little over $1 USD before the official version was even released in the US. Some analysts estimate that counterfeit goods out of China amount to between $50 and $60 billion dollars a year. The US-China Economic and Security Review Commission estimates that counterfeit goods represent almost 8% of China’s GDP.

It is certainly a huge problem that MNCs need to take into account when they develop their China strategies. Companies that can figure out how to solve the problem will do better going forward as they can tap into China’s emerging 250 million middle class. Investors should take note of the companies that can get out of the pirating quagmire and begin to turn a profit in China as the profits in China will reach levels that will begin to impact the bottom-lines of companies.

Luxury Products

Millions of Chinese are entering the ranks of the middle class and they want to look the part of urban aristocrat and consume luxury items like Louis Vuitton, Prada, Gucci, and Burberry. This means that they are willing to part with a large percentage of their salary to purchase a designer handbag, chic sunglasses, or Swiss watch like Rolex, and they often do. Over the last decade, the most popular luxury brands have become favorite targets of the counterfeiters who sold their wares at the famed Silk Road Market in Beijing and Xiangyang Market in Shanghai.

However, the situation is not all bleak for luxury producers. My firm conducted in-depth one-on-one interviews with aspiring consumers in Shanghai and Beijing. We found that consumers prefer to buy genuine articles if they can afford it. What respondents said is that they are buying real products and then completing their ensemble with fakes.

One female respondent said, “Right now I can’t afford to buy a lot of real LV or Coach (NYSE:COH), so I buy the fake items. I hope that in the future I will be able to afford the real thing, but right now I want to look the part.”

Another young woman pointed out that she did buy fakes but said that “if you wear a lot of fake clothing or have a lot of counterfeit bags your friends will know, so you are not fooling anybody. It is better to have the real thing. It does not make the brand worse if there are some fakes.”

One middle aged man said that “men do not have to have as many accessories as women so it is better to just save money and buy a real watch from Omega or a real bag. You won’t be proud of a fake.”

Thus, investors should realize that while piracy has been a problem in China for luxury product companies and brands like Polo Ralph Lauren (NYSE:RL), Nike (NKE), Pfizer’s (NYSE:PFE) Viagra, and Callaway (NYSE:ELY), the situation will get better because Chinese consumers want the real products when they can afford them and when there is a material benefit to having a genuine article. With increasing disposable incomes, the future is bright for purveyors of real products.

Software/DVDs

I am, however, less optimistic about software companies and media giants like Time Warner (NYSE:TWX), unless they become much more realistic in their strategies for combating piracy problems. They need to become less moralistic – i.e. stop whining that it is wrong for companies like Baidu (NASDAQ:BIDU) or pirated DVD producers to steal their intellectual rights. While they are morally and legally correct, their current posturing does little to stop the pirates or generate revenue from legitimate sales.

Instead, they need to go directly after the pirates from a business standpoint. There is limited benefit for most Chinese consumers in buying a real DVD over a pirated one in terms of the film quality. The executive from Time Warner who was also interviewed by Marketplace said: “Part of the strategy is to actually compete with the pirates.”

This is the right strategy, but Time Warner is not executing correctly. The company has just started putting out low-cost, legitimate DVDs on the street — for about $2 or $3 each. But that is still 3-4 times more expensive than the pirated DVDs. Unlike with software where Microsoft might send updates, there is no benefit to owning a real DVD over a pirated one, except that the subtitles might be better and one can guarantee quality (though most pirated DVD vendors will replace DVDs with little argument if they are found to be defective).

Given that the pirates are not going to go away on their own anytime soon, companies like Time Warner will have to learn to compete even more closely on price. They must sacrifice margins by going head to head with pirate,s but at the same time they will create an opportunity to sell to a Chinese market that is incredibly enthusiastic about Hollywood TV and movies. Even if it takes low cost products to reach Chinese consumers, companies have a lot to gain from selling directly to such a tech savvy society when they realistically cannot offer a compelling reason to buy the real thing.

Time Warner could also sell a wider range of film titles and embed coupons on the products or through digital media that get consumers motivated to buy the real products. As I wrote about for Knowledge Wharton, Chinese consumers want user created and interactive digital marketing campaigns like those created by Pepsi (NYSE:PEP). These campaigns create positive buzz and build brand loyalty and, most importantly, generate profits.

For instance, if Time Warner created campaigns where people who bought the legitimate copies of DVDs could be entered into contests to meet movie stars in Time Warner’s movies or win prizes, that might get consumers to switch to buying the real thing even if there was say a 10% premium (but certainly not 200-300% or more!).

But the interview on Marketplace shows me that Time Warner just does not get it in China.

Going Forward: Piracy in China

Investors interested in issues of IP protection in China should look closely at the efforts that software and media giants make to protect their products not by pure traditional means – i.e. they can now create compelling content that necessitates the purchase of genuine articles. When companies find the right mix of price and prestige they will reap benefits from China’s economic growth rather than crying foul while pirates take their bounty.

On the good side, China’s IT industry is beginning to bloom. Once enough domestic Chinese business interests are hurt by the pirates, you will see Chinese firms lobbying for better protection. And once they do, it is certain that the Government will pay attention and protect its wards. The piracy problem was huge and fixed in much the same way in countries like Korea and Taiwan. The stakes are bigger in China, so MNcs need to be more proactive rather than reactive in how they expand in China.

CMR Analysts Ben Cavender and Anna Li contributed to this article.

Source: Piracy From China: How Microsoft, Ralph Lauren, Nike And Others Can Cope