Microsoft has an emerging markets headache

On a trip to Beijing a decade ago, Bill Gates was asked by a senior government official how much money Microsoft made in China. The official asked the interpreter to double check Gates' reply as he couldn't believe the figure was so low.It's a problem that hasn't gone away. Indeed, Microsoft's current issues in China conceal a deeper problem for the US 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% 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.
Industry shifts
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.
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 in July 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% of its population - even though China bought as many computers as the US.
According to the BSA anti-piracy lobby group that Microsoft co-founded, emerging markets account for 56% of all PCs in use, and 73% of software piracy.
Pirate software
Of the $77.8bn revenue Microsoft generated in its 2013 financial year, China, Brazil and Russia each "exceeded" $1bn, according to a Microsoft presentation. For comparison, Apple generated $27bn in Greater China, which includes Hong Kong and Taiwan, in its 2013 financial year.
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, says Sameer Singh, an India-based analyst, since "convincing them to ship every PC with Windows pre-installed is difficult".
Margins on PCs for a company like Lenovo Group are "near single digits", said Bryan Wang, an analyst at Gartner.
The result is that up to 60% of PCs shipped in the emerging markets of Asia, said 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% 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.
Windows price
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' US home - China announced a new law requiring PCs to be shipped with operating systems. That merely dented piracy rates, which fell to 79% in 2009 from 92% 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.
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 licence 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".