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 Wednesday, July 25, 2007

Conquering China For Business: Learning the Lessons from Microsoft


David Kirkpatrick, Fortune senior editor

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"Mr. Bill Gates! Mr. Bill Gates!" a young woman shrieks as the black car pulls up.

A pallid student in a nylon windbreaker pushes his way through the security line and hands the world's richest man a small envelope with a floral design. "It's very important," he pants.

Another day in China, another round of adulation. Today the Microsoft (Charts, Fortune 500) chairman is being named an honorary trustee of Peking University. Yesterday it was an honorary doctorate from Beijing's Tsinghua University - the 13th in the school's 82-year history. Gates, wearing the same lopsided grin he has had on his face for the past few days, takes the envelope from the young man. For him this is a triumphant visit to China, a victory lap of sorts, on which I've been invited to tag along. The country is his.

No other Fortune 500 CEO gets quite the same treatment in China. While most would count themselves lucky to talk with one of China's top leaders, Gates will meet with four members of the Politburo on this four-day April trip.

As one government leader put it while introducing Gates at a business conference, the Microsoft chairman is "bigger in China than any movie star."

Last spring President Hu Jintao toured the Microsoft campus in Redmond, Wash., and was feted at a dinner at Gates' home. "You are a friend to the Chinese people, and I am a friend of Microsoft," Hu told his host. "Every morning I go to my office and use your software."

It was not always so. Microsoft bumbled for years after entering China in 1992, and its business was a disaster there for a decade. It finally figured out that almost none of the basic precepts that led to its success in the U.S. and Europe made sense in China.

There Microsoft had to become the un-Microsoft - pricing at rock bottom instead of charging hundreds of dollars for its Windows operating system and Office applications; abandoning the centerpiece of its public-policy approach elsewhere, the protection of its intellectual property at all costs; and closely partnering with the government instead of fighting it as in the U.S., a stance that has opened the company to criticism from human rights groups.

"It took Microsoft 15 years and billions of dollars of lost revenue to learn how to do business in China," says Sigurd Leung, who follows the company at research firm Analysys International in Beijing.

"We were a naive American company," concedes Gates in an interview in his car as he is driven to yet another meeting with government leaders. "You've got to just keep trying and trying and trying."

But now, he says, snacking on Pringles and Diet Coke, "we have a wonderful position in China, and we're going to see great growth every year for the next five years."

Gates says he's certain China will eventually be Microsoft's biggest market, though it may take ten years. Projected sales this year are already three times what they were in 2004, yet still less than annual revenue in California. (Microsoft will not disclose figures, but Fortune estimates China revenue will exceed $700 million in 2007, about 1.5% of global sales.)

Now Microsoft even has its own five-year plan in China, formulated to match up with the government's. Says Robert Hormats, a longtime China watcher at Goldman Sachs: "It's a great turnaround story with wonderful lessons for other companies."

False start
The story begins 15 years ago, when Microsoft sent a couple of sales managers into China from Taiwan. Their mission? Sell software at the same prices the company charged elsewhere. Says Craig Mundie, the top Microsoft executive who now guides its China strategy: "It was the classic model - hang out a shingle and say, 'Microsoft: Open for business.'" But the model didn't work.

The problem wasn't brand acceptance; everyone was using Windows. It's just that no one was paying. Counterfeit copies could be bought on the street for a few dollars.

As Ya-Qin Zhang, who heads Microsoft's Chinese R&D, puts it: "In China we didn't have problems with market share. The issue is how do we translate that into revenue."

Microsoft fought bitterly to protect its intellectual property. It sued companies for using its software illegally but lost regularly in court. Its executives, who often disagreed with the strategy, failed in its implementation. Country managers came and went - five in one five-year period. Two of them later wrote books criticizing the company. One, Juliet Wu, whose "Up Against the Wind" became a local bestseller, wrote that Microsoft heartlessly sought sales by any means, that its antipiracy policy was needlessly heavy-handed, and that her own efforts to help bosses in Redmond understand China had been rebuffed.

Then a different form of resistance emerged. Beijing's city government started installing free open-source Linux operating systems on workers' PCs. (The Chinese Academy of Sciences promoted a version called Red Flag Linux.) Meanwhile security officials were troubled that government and military operations depended on Microsoft software made in the U.S. Could the technology be spying on China?

In 1999, Gates sent Mundie, who heads the company's public-policy efforts, to figure out why Microsoft was so reviled. On the trip he had an epiphany: "I remember going back to Redmond and saying, 'Our business is just broken in China,'" Mundie recalls. He concluded that the company was assigning executives too junior and that selling per se was overemphasized. "But where we were most broken," he says, "was that our business practices and our engagement did not reflect the importance of having a collaborative approach with the government."

Mundie started visiting China four or five times a year. He brought 25 of the company's 100 vice presidents for a week-long "China Immersion Tour." He hired former Secretary of State Henry Kissinger to advise him and open doors. And he told leaders that Microsoft wanted to help China develop its own software industry, an urgent government priority. The company even commissioned a McKinsey study for Chinese officials in 2001 that, among other things, recommended improving the protection of intellectual property.

Mundie also began talks with Chinese security officials to convince them that Microsoft's software was not a secret tool of the U.S. government.

As a result, in 2003 the company offered China and 59 other countries the right to look at the fundamental source code for its Windows operating system and to substitute certain portions with their own software - something Microsoft had never allowed in the past.

Now when China uses Windows in President Hu's office, or for that matter in its missile systems, it can install its own cryptography.

But it was a relatively small step in 1998 - the opening of a research center in Beijing - that proved a turning point. "We just started it here because we thought they'd do great research," says Gates, who raves about the quality of the country's computer scientists. The lab was what Gates calls a "windfall" for Microsoft's image.

It began accumulating an impressive record of academic publications, helped lure back smart émigré scientists, and contributed key components to globally released products like the Vista operating system. The lab soon became, according to polls, the most desirable place in the country for computer scientists to work.

By 2001, Microsoft executives were coming to the conclusion that China's weak IP-enforcement laws meant its usual pricing strategies were doomed to fail. Gates argued at the time that while it was terrible that people in China pirated so much software, if they were going to pirate anybody's software he'd certainly prefer it be Microsoft's.

Today Gates openly concedes that tolerating piracy turned out to be Microsoft's best long-term strategy. That's why Windows is used on an estimated 90% of China's 120 million PCs. "It's easier for our software to compete with Linux when there's piracy than when there's not," Gates says. "Are you kidding? You can get the real thing, and you get the same price."

Indeed, in China's back alleys, Linux often costs more than Windows because it requires more disks. And Microsoft's own prices have dropped so low it now sells a $3 package of Windows and Office to students.

In 2003, Mundie and Gates took a quantum leap forward in China by hiring Tim Chen, who had been running Motorola's China subsidiary. Chen was a superstar, but when he was hired, articles in the Chinese press asked if he, too, would fall victim to the Microsoft "curse."

Chen arrived with entrée to the corridors of power and a practiced understanding of how a Western company could succeed in China. He kept up the blitz of initiatives. Microsoft made Shanghai a global center to respond to customer e-mails. It began extensive training programs for teachers and software entrepreneurs. It worked with the Ministry of Education to finance 100 model computer classrooms in rural areas.

"So with all this work," says Chen, "we start changing the perception that Microsoft is the company coming just to do antipiracy and sue people. We changed the company's image. We're the company that has the long-term vision. If a foreign company's strategy matches with the government's development agenda, the government will support you, even if they don't like you."

Microsoft put its money on the line, even inviting officials to help decide in which local software and outsourcing companies it should invest. So far Microsoft has spent $65 million, and it recently committed to an additional $100 million. Says Chen: "There was synergy, which we formalized, between the need of the Chinese economy to have local software capability and our need for an ecosystem of companies around us using our technology and platform."

At the same time, the Chinese government started thinking more like Microsoft: It required central, provincial, and local governments to begin using legal software. The city of Beijing completed its portion of the project late last year and now pays for software its employees - most of whom never adopted Linux - had previously pirated. (Microsoft won't say how steep a discount it offered the government.)

In another boost for Microsoft, the government last year required local PC manufacturers to load legal software on their computers. Lenovo, the market leader, had been shipping as few as 10% of its PCs that way, and even U.S. PC makers in China were selling many machines "naked." Another mandate requires gradual legalization of the millions of computers in state-owned enterprises. In all, Gates says, the number of new machines shipped with legal software nationwide has risen from about 20% to more than 40% in the past 18 months.

So did Microsoft conquer China, or is it the other way around?

Toward the end of Gates' trip, on the sidelines of China's Boao Forum, I sat down again with the Microsoft founder. One of the things I wanted to ask him was how he squares the company's "alignment" in China with its leaders' suppression of free speech on the Internet and what many consider to be their general disregard for human rights.

Our conversation, which had been flowing freely, ground to a halt. He said nothing. His silence lasted so long I found myself piping up out of discomfort. "That's a very pregnant pause," I said. "I don't think I want to give an answer to that," he finally replied.

Mundie, however, gamely ventured an answer in a separate interview. He started by talking about the challenges of transforming a socialist planned economy into one based on the market, and noted that never before have leaders anywhere attempted such a huge transition.

"Whether it's running a global company or a government," he says, "people have to sit there and make their own value judgments against what they deem to be the greater good all the time. I personally have found the Chinese leaders to be fairly thoughtful about these things. Each society makes choices to protect the rest of society. There are some aspects of that that happen here and in other countries that people would prefer didn't happen. But in the grand scheme of things, they're what people think is required to keep stability."

When I asked him if he had discussed any of this with China's leaders, he answered, "No. It's not what they consider to be my field of expertise. Nor do I."

This sort of language doesn't impress Sophie Richardson, an Asia expert at Human Rights Watch. She is distressed that Microsoft shut down the blog of a government critic on its MSN Spaces service in 2005. (Microsoft set up MSN in China with a government-owned investment firm.) "We're just not convinced they have done all they can to push the Chinese government," says Richardson. "Will they say no to initiatives in which they might stand to gain financially but which would oblige them to participate in the repression of rights? I may not have high expectations of [Chinese search company] Baidu as a defender of free speech, but I do of Bill Gates."

Many multinational companies would love to be in Microsoft's shoes. Says Carl Bass, CEO of Autodesk (Charts), the $2-billion-a-year design-automation company: "To do business in China you have to work closely with government." Sean Maloney, who heads marketing at Intel (Charts, Fortune 500), agrees: "You can't do too many investments in China that the government doesn't approve of. You might as well ask them."

Microsoft's China strategy is clearly paying off. More than 24 million PCs will be sold this year, adding to the 120 million already in place.

Although the company's China revenues average no more than $7 for every PC in use (compared with $100 to $200 in developed countries), Gates says those figures will eventually converge.

"What we have here is not about me, and it's not about where President Hu went to dinner or anything like that," he says. "It's an institution-to-institution relationship, where we've really found a win-win way of doing things together that will generate a substantial part of Microsoft's growth in the next decade. I don't know any company in the IT industry where things have worked out as well as they have for Microsoft."

And not badly for China either.

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