Piracy Drives Microsoft To The Cloud

| About: Microsoft Corporation (MSFT)

Microsoft (NASDAQ:MSFT) launched the Windows Server 2012 cloud operating system in China on Sept. 18. This is the first time that the Windows Server 2012 OS has taken up the cloud design. It is the successor to Windows Server 2008 and comes in time for the launch of Windows 8. Both Windows 8 and Windows Server 2012 will feature the new user interface.

Microsoft's strategy in China, where rampant software piracy is one of the biggest challenges, is to direct the sales and marketing efforts toward local government and public organizations, which has been its bread and butter in the U.S. Microsoft earns as much in China as it does in the Netherlands, a country whose population is just about 1% of China. Even with a similar amount of PC sales, Microsoft's revenues from China are about 5% of its U.S. revenues.

The company is suing Gome Electrical Appliances Holdings for using a pirated version of Windows. Gome is one of the leading domestic electrical appliances manufacturers in China. With a market cap of more than $1.7 billion, its use of pirated software highlights the challenges in the Chinese market. Despite this, the company is expanding its workforce in China by 1,000 to 5,500 employees, which will give Microsoft a workforce in China that will be nearly as large as the one it has in India.

Piracy is why Microsoft is focusing on tablets for the future over PCs, as the OS is shipped as a ROM with the device and you can't buy a blank tablet and load the OS on it, bypassing the license fee. The OS is married to the hardware, which destroys the opportunity for piracy and affords Microsoft the opportunity to capture that lost revenue in Windows 8/RT licenses. Bundling Office with all Windows 8/RT tablets lets the company ensure it monetizes both cash cows more effectively, albeit at a lower price. The license fee most widely quoted for Windows RT is $85.

Microsoft's hopes are tied up with Windows 8 in all of its permutations, and in the smartphone space its partnership with Nokia (NYSE:NOK) has not yet caught fire in China, although their phones are selling better than in the U.S. Their first big win over Apple (NASDAQ:AAPL) is in the can, however, as the new Lumia phones will be on China Mobile (NYSE:CHL) starting in mid-December. China Mobile's variation on CDMA has kept Apple off the carrier and there has not been any movement yet on Apple's part to address the more than 1 billion subscribers on the world's largest carrier.

But Microsoft's strategy is far deeper than just smartphones; if anything, it is the company's entrenched enterprise business that it is trying to leverage to gain smartphone and tablet market share. Microsoft already has its second largest research base in China, with 13 offices located in provincial capitals and economic centers such as Beijing, Shanghai, and Shenzhen. It invests $500 million each year in its R&D base, which serves as its Asia-Pacific headquarters. It is also building a new cloud computing base in Shanghai to keep pace with the data center that Apple just announced it is building.

According to the latest available data, Microsoft/Nokia have around 4% of the smartphone market in China, behind Apple's ~10%. That is worrisome for Apple because it is obvious at this point that Google's (NASDAQ:GOOG) Android is running away with the market, and Apple's drop in market share is being devoured by Android.

The race in smartphones and tablets, where Apple's advantage is as large as Android's is in smartphones, is the front line battle in the war because even in China PC sales are slowing rapidly. PC shipments in China dropped for the first time ever by 5.4% recently, which is worse for the chip manufacturers than Microsoft as it may be losing revenue due to piracy, but Windows is still running on 90% of the desktops.

It should be noted that software piracy is a global issue rather than just a Chinese one. In 2011, the U.S. was the worst culprit in the illegal software market, pirating software worth $9.8 billion followed by China with $7.8 billion. The U.S., however, is also the best market for legitimate software sales at $41 billion.

In a nutshell, Microsoft has invested billions in China, but its revenues from there are negligible. The ecosystem strategy is less about selling individual software licenses than about creating the platform to serve apps and advertising. The development of its cloud server along with its cloud-based tools for small business removes the a lot of the incentive for piracy, as it is selling not just the software itself but the environment, data storage, and so on.

The way to get anyone to pay for something they may be able to get for free is to make them a better offer. Fighting piracy through the courts is expensive and ineffective. Altering the business model and bowing to the wisdom of the customer makes more sense in the end. And that's the idea behind its new subscription model for Office 365 for home or business. Whether Microsoft has done that with their new pricing model in the face of LibreOffice and its own free web versions of Word, Excel, and OneNote is a different story.

Microsoft is betting on the cloud at the institutional level to trickle down to the consumer level. Also, it is offering a great value-add for both the individual and family who needs multiple Office licenses for work at home and school. So, while free software is both fantastic and useful in so many ways, it is also a trap of potential inefficiency and an impediment for a small business/freelancer. The number of people who work at home in the U.S. is currently 26 million and rising rapidly. This trend will continue the world over, and people will need to have professional tools of the same software version available to them on demand. Skype is practically a necessity for those people now, and so is Word. Being able to ensure that you are compatible with a potential employer's tools is a powerful motivator to get legal. And it may just be the key to Microsoft building a revenue stream in the biggest potential market in the world.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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