Microsoft's Biggest Problem Is Piracy

| About: Microsoft Corporation (MSFT)

In a combination of recessionary conditions in the West and explosive long-term growth in the Asia, global dynamics have changed. For corporations, areas of growth and revenue are increasingly shifting to Asia. Herein lies what I believe is Microsoft's (NASDAQ:MSFT) biggest problem: piracy. While hardware makers such as Apple (NASDAQ:AAPL) have been enjoying explosive growth due to increased exposure to Asian markets, Microsoft has been struggling. In China, Asia's biggest market, about 80% of sold software was pirated. It is claimed that about 95% of Microsoft software sold in China was fake. This prevents Microsoft from tapping into global growth, as these markets are where it's situated.

A Complex Problem
Unfortunately for Microsoft, the problem is very complex and almost impossible to solve. The largest hurdle is price. Before Windows 7 came out, pirated versions of the software were available for just 20 yuan, or $2.93. In comparison, Windows sells for as much as $320 in the U.S. With the Chinese government taking little action to prevent pirating, why would a Chinese customer buy a version of the software that is more expensive and releases later?

Microsoft's Attempts at Solutions
Microsoft has tried price reductions. However, it will never sell for nearly as low of a price as the software sells for illegally, so lowering the price makes little of an impact on piracy rates, and lowers revenue. It is not a viable solution.
Microsoft has tried to ruin the experience on pirated software. Last year it began a program that would display a black screen every hour to users of illegal copies of Windows XP. This didn't work either, as users refused to pay and instead switched to free software such as Kingsoft.

With little other cards to play, it doesn't seem like Microsoft has any tricks up its sleeve to solve this revenue-sucking problem.

As An Investment, Microsoft Is Hit Hard
I already mentioned how hardware companies are much better positioned to benefit from global growth because their products are much harder to copy and sell for fractions of the price, while maintaining a similar user experience. This is moving investment to corporations like Intel (NASDAQ:INTC), with hardware that is nearly impossible to copy well. Or Google (NASDAQ:GOOG), which offers free products, giving no incentive to pirate. Microsoft needs a solution.

Potential Solutions
Microsoft does not have a lot of options to take advantage of growth in Asia, but some possibilities are there.

  1. Mobile. There are reasons why Microsoft is currently pushing Nokia (NYSE:NOK) so hard to succeed and is putting so many resources behind the Windows Phone. The obvious reason is the current mobile revolution. The less obvious, but similarly important reason is the nature of the software business on mobile devices. When a device is sold, Microsoft makes money because its operating system is included and paid for by the manufacturer, whether a laptop or phone. The problem with laptops is that cost-watchful customers keep them for long periods of time, and during this time, in countries like China, they tend to not pay for new software and software updates. Smartphones, however, have much shorter lifespans, mostly because they're less of an investment but also partly because they're more reliant on battery life. Carriers also tend to heavily entice new purchases to extend contracts. Microsoft's long-term profitability therefore depends heavily on its success in the mobile market both because of piracy and the mobile revolution.
  2. Freeware. Although this will most likely never happen, I believe that Microsoft should explore the possibility of offering low-end versions of its Windows and Office lines for free. Revenue would be made from advertising and in-app upgrades. This would be beneficial because it could potentially kill a large part of the underground piracy market for Microsoft products, which in the long run will change consumer views on downloading illegally, as it will become less of a norm. This combined with intelligent campaigns to encourage users to upgrade to premium versions of the software, as well as advertising revenue, could work well for Microsoft in the long run. Of course, the company would most likely take a revenue hit in the short run, a risk that management will most likely never consider.

You may now think that I don't believe that Microsoft is a good investment. To the contrary, I think that it has a lot of upward potential:

  1. Even if Microsoft finds no solution to the piracy problem, piracy rates will decline over time. As China's economy grows and its middle class becomes larger, more will begin to purchase legitimate versions of software.
  2. The U.S. is frustrated with China's treatment of several sectors of U.S. international business, and may begin to adopt more aggressive policies to force China to make markets more fair. This could play well for Microsoft, as the Chinese government may begin to put efforts into piracy prevention.
  3. As I mentioned in several of my previous articles, I strongly believe that Microsoft will begin to succeed in mobile by the end of 2012. Check out my previous articles to see why.
  4. Microsoft's sales of IBM-like business solutions are becoming an increasingly large source of growth, and are much less prone to piracy.

Microsoft is currently not the best play on global growth in software and technology. But that only makes me more bullish on the stock. When I evaluate an investment, I look for stocks that are not favored, but that have various developments that could strongly shift their situations. Microsoft is one of these. Its stock is doing decently well, and that is without strong growth (at least compared with potential growth) in major developing markets. If piracy rates decline sharply or Microsoft succeeds with the Windows Phone (or both), there is absolutely huge upside on this stock. If neither occurs, Microsoft is only trading at around 11 times P/E, so downside is very limited. In the meantime, you can enjoy a safe, solid dividend.

Note: I do not currently hold any positions because my portfolio is already overexposed to PC and Windows Phone prospects (I own Intel and Nokia). However, if there is a pullback, I may add a Microsoft position.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MSFT over the next 72 hours.