April 25, 2008 11:47 AM PDT

Microsoft's piracy problem could grow

Posted by Ina Fried

When it comes to software piracy, Microsoft may just be aiding the enemy.

Microsoft has been counting on gains against unlicensed software to boost revenue from the Windows unit, which accounts for a huge chunk of overall profits and sales. However, one of the company's own decisions could make its antipiracy battle more difficult.

With Windows Vista, Microsoft took an extremely tough stand on piracy. Computers that were not properly activated within a short period of time went into a virtually unusable state known as "reduced functionality mode."

In the newly released Service Pack 1, however, Microsoft is softening its stance somewhat. The reduced functionality mode is gone, and in its place, a series of warnings and visual indications that a computer is not running a genuine copy of Windows.

I would argue, though, that having an unusable copy of Windows is a far greater deterrent than having one that simply labels its user a pirate. Microsoft has maintained that the new approach will be just as effective and is more palatable to customers and partners. Color me skeptical.

But, will the changes automatically lead to an uptick in overall piracy rates? That's a more complicated question.

On its face, it would seem the answer would be a clear "yes."

However, there are a couple of other factors to keep in mind. First, Windows XP is pirated far more than Vista (at least 2 to 1, according to Microsoft). Also, Microsoft did close several notable hacks to its Vista protection scheme with SP1. So while the price for piracy is arguably lower, Microsoft has closed a few loopholes that let pirates bypass the security features altogether.

Time will tell whether Microsoft's technical changes will have an impact on the broader piracy issue. Enforcement is also key, with Microsoft CFO Chris Liddell noting that a couple of legal actions can make a big difference in any given quarter, suggesting true gains (or losses) from piracy require looking at a longer time horizon.

What is clear is that piracy rates remain a critical issue for Microsoft, which needs to continue growing its Windows revenue and profits to help fund its advertising battle against Google.

Microsoft had seemed to be making major headway against piracy, surprising analysts and itself in the September quarter by gaining 5 percentage points of growth through piracy reductions. Last quarter, though, Microsoft actually saw piracy rates head upward, reversing what had been a particularly positive trend for the company.

Microsoft now expects its gains for the year to be just a percentage point or two, though it believes it can continue to see improvements next year as well.

"Piracy is a tough battle and an area where we will need to continue investing," said Colleen Healy, Microsoft's general manager of investor relations.