China's president Hu Jintao kicked off his recent U.S. visit not by checking in first at 1600 Pennsylvania Ave., but by meeting Microsoft Chairman Bill Gates. The social call may have paid off. On Apr. 26, the Redmond (Wash.)-based software giant announced plans to invest $900 million in Chinese software companies and hardware over the next five years. The aim is to reduce piracy rates and establish Windows as the dominant operating system in the region.
The deal represents Microsoft's biggest commitment to China to date. The company said in 2002 it would invest $750 million in Chinese companies and products over three years, a period the company and China have dubbed Phase I of Microsoft-China relations. Microsoft (MSFT) is now upping the ante on investments. Microsoft, with China's National Development & Reform Commission, will also establish a development center to boost capabilities of Chinese software companies. In addition, Microsoft will train 10,000 Chinese software engineers.
These aren't mere goodwill gestures. Gates & Co. aim to reduce the rampant unauthorized sales of Windows at Chinese shops and bazaars. Microsoft also hopes the deal will result in wider use of its Windows operating system in China, where the PC market is growing at a double-digit pace, representing "the world's best opportunity [for PC software sales]," says Roger Kay, president of tech consultancy Endpoint Technologies Associates. Microsoft, looking to step up growth, clearly wants a slice of the pie.
PIRACY PEAKING. To now, Microsoft's investment efforts have made little headway in reducing piracy. The company should be booking about $1 billion on annual sales of some 20 million PCs in China, says Paul DeGroot, an analyst at consultancy Directions on Microsoft. Instead, sales there are about $100 million, he says. The PC makers don't pre-load Windows on their computers, and consumers install pirated copies of the operating system on their own. Software piracy has fallen a few percentage points in China in recent years, according to a 2005 survey by Business Software Alliance, an industry consortium fighting piracy. But it's still at an eye-popping 90%, and the decline has more to do with the country's growing prosperity than Microsoft's investments, DeGroot says. Now that they make more money, users can afford legal versions of Windows.
Microsoft tried to block Kai-Fu Lee, an executive in its Chinese operations, from joining competitor Google (GOOG) last year. During court proceedings, Lee said Microsoft botched efforts in China by failing to make friends with the Chinese government early on. The software company may be making up for lost time. Some analysts say Microsoft could finally see returns in the next two years.
GOVERNMENT SUPPORT. The Chinese government appears to be making efforts to reduce piracy. On March 31, China announced it would require all new PCs to be shipped with pre-installed, legal operating systems. While many PC makers will likely opt for the cheaper (or free) Linux system, the policy could boost legal sales of Windows as well. And on Mar. 30, three Chinese government agencies began requiring that all PCs they buy come pre-loaded with Windows.
Partly due to the Chinese government's thaw, Microsoft is gaining traction with Chinese computer manufacturers. On Apr. 18, on the eve of Hu Jintao's arrival at Gates' house for dinner, Yang Yuanqing, chairman of Chinese PC maker Lenovo, signed an agreement with Microsoft to jointly market PCs in China.
Before then, last November, when the PC maker has agreed to pre-load Windows onto Lenovo-branded PCs, fewer than 10% of which came with Windows (the rest used Linux and DOS).
SOLID INVESTMENT. Today, 70% of Lenovo-branded PCs in China have Windows XP pre-installed. "It gave us a competitive advantage over other PC makers who weren't shipping Windows," says Yang. "We were the first to start doing this. It improved the image of the company." Lenovo acquired IBM's (IBM) PC business last year. Now, more local PC makers are flocking to Microsoft. Recently, the company signed deals to bundle Windows onto PCs made by several other Chinese manufacturers. The financial impact of the Chinese deals on Microsoft is as yet unclear. But "any incremental [downward] change in the level of piracy is incremental revenues for Microsoft at [virtually] no incremental cost," says Peter Misek, an analyst with Cannacord Adams. In fact, some analysts, DeGroot among them, believe that Microsoft should be able to recoup its $900 million investment within two to three years. "The return on that investment is not certain," he says. "But it could pay off."
"BLIND EYE." Meantime, Microsoft can console itself that as Windows gains popularity in China (legal copies or no) consumers are less likely to opt for Linux, says Jim Murphy, research director at consultancy AMR. "The dilemma is, do they turn a blind eye now in order to have opportunities down the line?" he says. "The space between the rock and the hard place is getting tighter."
But Chinese consumers are getting used to the Windows interface and functions. Those who use pirated copies -- as their incomes rise -- could be enticed to pay for legitimate versions of Windows that have more features or fewer glitches, DeGroot says. Microsoft is clearly only at the beginning of a long road to overcoming piracy. But the right balance of statesmanship, investment and marketing are a step in the right direction.
Kharif is a writer for BusinessWeek in Portland, Ore.
with Steve Hamm in New York and Sarah Lacy in Silicon Valley
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