When Microsoft releases Office XP in a few months, the company will face off against its two toughest competitors: software pirates and, well, Microsoft. On one front, Microsoft must convince as many as 120 million Office 95 and 97 users to upgrade to the new version, an opportunity customers passed on with Office 2000. On the other front, the Washington-based company must combat lost sales to casual and professional pirates. In North America alone, potentially one out of every four copies of Office is pirated, meaning it was copied illegally. "Microsoft's biggest competitor may in fact be software pirates, just as their biggest competitor is their installed base," said Prudential Securities analyst, James Lucier. He said that with so many different versions of Office or Windows available, "there's just no adequate incentive for people to move up." Interestingly, Microsoft is marshalling similar tools to deal with both problems. With the first package of bug fixes -- or service release -- to Office 2000, Microsoft introduced activation technology that makes pirating the software more difficult. With Office XP and, later, Windows XP, Microsoft will refine the technology, essentially "locking" the software to the user's PC configuration. Also with Office XP, Microsoft will begin selling software on a subscription basis, under which customers pay a fee for using the product for a predetermined time period. While the move is largely viewed as a way of generating additional revenue, the subscription scheme could also undercut piracy. "Moving all of their software to a subscription basis is the ultimate way to combat piracy, because then you're not going to get anything unless you're a subscriber," Lucier said. Moving more customers to a subscription basis could also diminish competition from older versions of Office, as customers would pay for incremental upgrades as they became available. For Microsoft, its ability to successfully reduce piracy and move more people to Office XP is vital to the company's financial success in a soft economy and at a time when technology sales are slowing, analysts say. About 46 percent of the company's revenue, and more than 50 percent of income, is derived from Office, making it Microsoft's most important product line -- maybe even more so than Windows. But Office sales are slowing, with revenue during Microsoft's second fiscal quarter declining 2 percent year over year to $2.49bn from $2.53bn. The fiscal third quarter is expected to be flat or show similar declines. "No other product is more important to Microsoft than Office," said Gartner analyst, Chris LeTocq. "Any slowdown in Office sales is bound to hurt the whole company." Particularly as Microsoft prepares for perhaps the most important strategic shift in its history -- moving to Windows XP and the Microsoft .Net software-as-a-service initiative -- strong Office sales could be essential to carrying the company through the transition. With the North American market saturated, Microsoft must expand Office sales in other geographic regions. But in many of those areas, the company faces stiff competition from casual and professional software pirates. Technology trade groups, the Business Software Alliance and the Software & Information Industry Association, (SIIA) estimate about 25 percent of business software used in the United States is pirated. Worldwide, the rate jumps to 36 percent, but in some of the most important growth markets, the rate is much higher. In China, for example, more than 90 percent of software is pirated. In some smaller markets, such as Vietnam, the piracy rate jumps to 98 percent. "If you have factories in China ripping off Microsoft product, clearly this is a problem," Lucier said. "You have the Chinese government saying Windows is the tool of American imperialism and saying, 'We want our world to run on Red Flag Linux.' That's a serious problem for Microsoft." Microsoft wouldn't say how much money it loses worldwide to piracy, but the SIIA puts the figure around $12bn a year for all companies selling business software. In China, the loss is $650m. But Microsoft, because of its market dominance, may be disproportionately affected. LeTocq said Office's market share is "in the low nineties in the US, and in the eighties most everywhere else." "If you take the market in China, yes, Microsoft probably is disproportionately taking the brunt of the piracy problem because it is the dominant player there," said Peter Beruk, the SIIA's vice president of antipiracy. This could mean Microsoft's piracy rate is much higher in many markets, and well above the 36 percent worldwide average. The company would also face higher losses -- and on its most profitable product line. "It does seem to make sense that the popularity of Office would increase the piracy rate," said Microsoft corporate attorney, Tom Cranton. "I can't tell you from an informed perspective. All I can tell you is, yeah, certainly that is something you would want to consider when looking at the piracy rates." But such untapped revenue has proved elusive for Microsoft and potentially more difficult to mine, given the North American high-tech sales crisis. Microsoft's activation technology, for as long as it stays ahead of the pirates, could be an important tool to fight piracy in China and other burgeoning markets, Lucier said. A move to subscription-based computing could have an even greater effect. "Obviously, it's a great way to expand their revenues," he said. "If you can turn just 10 percent of their losses into China legitimate sales, you obviously have significant revenues there." But some analysts warn that Microsoft could kill the golden goose while trying to minimise losses. "In the Chinese market, they're very sensitive that Microsoft is a tool of US nationalism, and here is an approach that may give them reason to stick with generating illegal copies of Office 2000," LeTocq said. China and other growth markets also could switch to competing products, such as Sun Microsystems' StarOffice. "It's free and also comes in a Linux version, which might appeal to the Chinese," LeTocq added Microsoft's bigger challenge may be rustling Office sales on its home turf, North America, where it faces competition not only from piracy, but from older versions of Office. Tom Bailey, lead product manager for Office XP, estimates that as much as 60 percent of Office users have stuck with a version older than Office 2000. LeTocq said there is good reason for that: "Microsoft simply hasn't given users a compelling reason to upgrade. What they've got works, so why switch?" Since many companies upgrade with every other version of Office and the majority of users are on Office 95 or 97, Microsoft could see some demand for Office XP after its expected late-May release. Cajoling customers into paying on a subscription basis would be one way to reduce and eventually eliminate the problem of competition with older versions. Office users paying by subscription would always have the latest version. However, "this is a very critical time for Microsoft to adjust how this works," LeTocq said, referring to how people pay for Office. Microsoft released gold code to Office XP last week but doesn't plan to sell the new version at retail until late May or early June. But corporate customers subscribing to Microsoft's licensing programs are expected to get Office XP sometime in April. "Microsoft clearly is being cautious with the locking feature and subscription scheme," LeTocq said. "That's why they're holding back on retail." On the one hand, the company wants to reap as much up-front sales of the full version as possible, before fully exposing the subscription payment option. "The subscription thing is more a long-term play for Microsoft," Le Tocq said. Besides potentially cutting down Office-to-Office competition, the subscription scheme and activation wizards may be tools for thwarting piracy. "The more software becomes a service that requires a key or some more tightly controlled access, you're going to see more piracy taken out of the picture," Lucier said. The activation mechanism, which locks Office to a particular PC configuration, is expected to help combat casual piracy, such as friends sharing copies of Office or small businesses buying one copy for many PCs. "We found that the vast majority of piracy is this kind of casual piracy," said Lisa Gurry, a product manager for Office XP. "This Office activation wizard is designed to combat this casual piracy." If successful, the mechanism could tap another source of Office revenue as more legal copies are sold. But LeTocq believes customers forced to use the activation mechanism, which is a mandatory feature to use Office, may baulk and upgrade no further than Office 2000. "It's interesting that Microsoft uses the word 'activation,' when it's really locking the code to a particular PC," he said. "That carries a different connotation, and Microsoft knows this." What's happening in the world of Windows? Find out with ZDNet UK's Windows Special. Have your say instantly, and see what others have said. Click on the TalkBack button and go to the ZDNet News forum. Let the editors know what you think in the Mailroom. And read other letters.