China Software Outsourcing Industry -


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The Chinese software outsourcing industry is a symbol of China’s great leap forward from a focus on industry to services. In less than five years, China, by leveraging its low-cost labor and driven by government ambition, has become one of the most important software outsourcing destinations in Asia. Solidiance examines the ups and downs of China's entry in the Software Outsourcing business.

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China Software Outsourcing Industry -

  1. 1. China: software outsourcing industry Solidiance examines the current market and implications for growth July 2009
  2. 2. China: Software Outsourcing Industry Solidiance examines the current market and implications for growth The software outsourcing industry is a symbol of China’s great leap forward from a focus on industry to service. In less than five years, China, by leveraging its low-cost labor and driven by government ambition, has become one of the most important software outsourcing destinations in Asia. Unfortunately, the global economic slump, the appreciating RMB, and new labor laws in 2008 have “ Even in the current downturn, we are expecting margins to increase at least 20% in 2009... The Chinese software outsourcing industry will emerge more started to curb growth in this previously soaring sector. For the first time, companies in this sector are mature by the end of this year. ” experiencing declining orders, tougher contractual terms, and the need to re-configure their talent pool to Dr. Liu Ji Ren – Board of Directors, Neusoft meet irregular market demand. In light of current changes, this paper presents our views on the road ahead for China’s software outsourcing industry, its challenges and opportunities. 2
  3. 3. China: Software Outsourcing Industry Solidiance examines the current market and implications for growth When Healthy Growth Meets Economic Storm A Giant Leap past 2 years), as well as rising human capital costs resulting from more restrictive labor laws in 2008. China’s software outsourcing industry achieved an impressive growth rate of 38% year-on-year from 2004 This fast growth created a fragmented market with to 2008. Driven by strong government support, active many small and medium size players. There were over involvement from venture capitalists, and growing IT 8,000 players in 2008, and the largest, such as Neusoft, budgets from clients experimenting with new hi-tech Insigma, Hisoft, and Vanceinfo, have roughly only 5% productivity tools, the Chinese market size for software market share each. The number of players is expected outsourcing reached USD 2.6 billion in 2008. to consolidate down to 3,000 over the next two years, through both competitive elimination as well as Many Victories, yet Many Challenges potential mergers and acquisitions (M&A). This has It all started in three cities - Dalian, Beijing, and been cited as a positive advancement for the Chinese Shanghai - in early 2003. Having seen encouraging software outsourcing industry, because the remaining, success, the China State Council offered incentives to stronger players will be those with a better chance to grow the sector. As of Feb 2009, there were 20 cities compete for higher value outsourcing deals currently designated as ‘window cities’ to house software served by Indian outsourcing companies. outsourcing companies. However, another challenge faced by the sector amid An important development over the past five years was the economic slump is a drop in large value orders. the gradual movement from low-value outsourcing work, Over the past six months, the industry has seen fewer typically the result of multiple layers of sub-contracting, USD 10 million orders, yet it is still under pressure to towards mid-end outsourcing work, involving greater maintain the staffing levels set during recent boom levels of consultation and design. This was driven by years. Firms are starting to question when they will see the improving technical competence of Chinese these multi-million dollar deals again, and in spite of the outsourcing providers, the rising pressure on margins spending downturn and consolidation among peers, for low-end work resulting from Renminbi (RMB) what steps should be taken to facilitate survival and appreciation (RMB appreciated 15% against USD in the future growth. + Uncertain Future Economic Storm = 3
  4. 4. China: Software Outsourcing Industry Solidiance examines the current market and implications for growth Market: To Grow or Not To Grow – Drivers Market Growth Drivers for China’s Software This trend creates a lucrative market for software Outsourcing Industry outsourcing service providers. 1.Transfer of outsourcing business from India. 4. Strengthening of the Japanese Yen improves margins earned by Chinese service providers. Some recent events have damaged India’s credibility as the world’s top choice for software Approximately 50% of China’s software outsourcing outsourcing. For example: business comes from Japan and contracts are mainly signed in the Japanese Yen currency (JPY). The chart – The December 2008 terrorist assault in Mumbai. above shows that the appreciation of JPY will lead to – The billion dollar accounting scandal at Satyam, India’s higher revenues and margins for Chinese software 4th largest software outsourcing company. outsourcing companies. The strong JPY trend of the −World Bank’s blacklisting of Wipro, India’s 3rd largest first quarter 2009 will benefit the profitability of China’s software outsourcing company. software outsourcing industry. “ 2.Chinese government’s support of the software outsourcing industry. We have already seen some global clients −The state council announced a special 15% tax cut shifting their outsourcing partnerships effective February 2009, until the end of 2013, for outsourcing companies. This incentive allows more room from India to China and the trend will ” for outsourcing companies to learn to survive and no doubt continue. compete. −The economic stimulus package will also support industries such as telecom and energy, which are key Ms. Sun Xin Fang - CEO of Chinasoft customers of China’s software outsourcing industry. 3.The growing need for unified software and processes in Exchange Rate (100 JPY Against RMB) Neusoft’s Margin vs JPY Exchange Rate China. 7.6 45% Neusoft’s Margin% 7.4 40% The integration of Chinese companies 7.2 7.0 35% 30% into the global business arena and rising M&A activities 6.8 6.6 25% 20% increases the need for unified software and processes. 6.4 15% 6.2 10% Within the first two months of 2009, Chinese companies 6.0 5% 5.8 0% spent USD 21.8 billion acquiring international companies, a 40% increase year-to-year. Now Chinese multinational JPY exchange rate Neusoft's margin corporations (MNCs) face the challenge of integrating and (The table above shows the relationship that Neusoft’s margin rate increase when JPY consolidating supply chains, logistics, information appreciates and vise versa) technology and human resources, among other functions. 4
  5. 5. China: Software Outsourcing Industry Solidiance examines the current market and implications for growth Market: To Grow or Not To Grow – Barriers Market Growth Barriers for China’s Software Outsourcing Industry “ 1.Global economic downturn. The global software outsourcing industry as a whole is affected by the current economic slump. In Of Beyondsoft’s past clients, India for example, which holds approximately 40% of the global software outsourcing market, the market is still approximately 30% were unprofitable growing but the pace of expansion has slowed down. projects. We were backed by VCs and in After expanding by 35% in 2007, growth was about 15% order to achieve high revenue, we in 2008. Solidiance interviews show the market expects growth to diminish further to around 7% in 2009. accepted all projects, even small Reasons affecting growth for outsourcing include: orders. Oftentimes the sales cost was −Global CIOs are cutting IT budgets and renegotiating already 25% of the price and there was ” contract terms – in many cases a lower price for the same amount of work. very little room for margin. −Outsourcing decisions are being delayed or canceled, Mr. Wang Bin - CEO of Beyondsoft which will affect the volume of contracts sold in Q1 and Q2 2009. Historically, companies would consider outsourcing towards the end of a market downturn. Recent Solidiance interviews show it could take even longer this time as the overall investment sentiment has dropped significantly. Executives are cautiously handling their outsourcing budgets and will hold back investments until they see a sustainable economic recovery. 5
  6. 6. China: Software Outsourcing Industry Solidiance examines the current market and implications for growth Market: To Grow or Not To Grow – Barriers “ 2. Reality check on profitability of projects. The recent growth in China’s software outsourcing industry was fueled by venture capital (VC) investment We started to feel the heat of the and initial public offerings (IPOs), and the main economic downturn several months measurement for success was turnover, not profit. As ago. Customers started to demand 25% a result, companies accepted all types of projects, including non-profitable ones, to boost revenue growth more work for the same fees we charged ” and client count. Now that labor costs are increasing a year ago. and IPO listings are less likely to materialize, outsourcers are re-examining their portfolio and will be Solidiance interview with an anonymous medium sized less inclined to accept projects that may appear software company in China unprofitable, thus reducing growth. 6
  7. 7. China: Software Outsourcing Industry Solidiance examines the current market and implications for growth Conclusion on Market Growth/Decline To Summarize China’s Software Outsourcing Market in 2009 Impact Drivers “ • Chinese government's economic stimulus package • Chinese government's tax incentive to the software outsourcing industry The Chinese market will keep • Chinese companies increasing overseas M&A growing, but the growth rate will • Indian outsourcer's diminishing credibility decline to 15% in 2009 and will recede • Expected appreciation of JPY against RMB further to 10% in 2010. ” Barriers • IT budget cuts due to economic slump Heiko Bugs - Director, Solidiance • Delays in software outsourcing decisions • Part of software outsourcing sales in 2007/2008 attributed to a ‘bubble’ as companies took up unprofitable projects • Expected depreciation of USD against RMB China’s Software Outsourcing Industry Market Size 3.5 3.3 60% 3.0 Market Size (USD Billion) 3.0 50% 2.6 2.5 Growth Rate 2.0 40% 2.0 1.4 30% 1.5 0.9 20% 1.0 0.6 0.5 10% 0.0 0% 2004 2005 2006 2007 2008 2009 2010 (The table above shows that market growth will slow down in 2009 and 2010) 7
  8. 8. China: Software Outsourcing Industry Solidiance examines the current market and implications for growth Market Player Structure – What’s Next China’s Software Industry IPO Value During the growth period between 2004 – 2007, high 4,000 growth potential attracted numerous VCs, including 3,250 -91.2% 3,000 Granite Global Ventures and Tiger Fund, to put 2,000 significant investment into China’s software outsourcing 1,000 286 industry. This helped companies to grow quickly and 0 2007 2008 launch their IPO. This growth model ended with the (The table above shows that China’s software industry IPO total value decreased 91.2% in 2008 compare to 2007) advent of the current financial crisis. World’s Major Venture Capital’s ROI In 2009, major drops in the global stock markets have 30% 25.10% resulted in low returns on investment (ROI). -79.7% 20% Furthermore, IPO activity has all but dried-up. This trend means other financing channels are needed. 10% 5.10% Listed companies such as Neusoft and Vanceinfo, have 0% 2007 2008 an advantage since they are well capitalized. They also (The table above shows that world’s major VC’s ROI decreased 79.7% in 2008 compare to have the option to issue new shares, which would fund 2007) them to acquire additional resources from small to The chart below shows the level of fragmentation of the medium-size companies that are in financial distress. Chinese software outsourcing industry. The small and The most important strategic imperative for the medium sized players that are cash-tight will struggle to software outsourcing industry is expansion. The size of survive through the current economic downturn, while a company’s work force (along with its educational level, the larger players with a bigger pool of well-trained and efficiency, and experience) is the measure of the ability experienced staff, will continue to capture more of the to do large software outsourcing deals. Top Indian pie. companies with staff of over 100,000 people have the Market Share in Terms of Off-shore Software Outsourcing Revenue Q3 capability of doing deals worth over USD 100 million. 2008 7% Top Chinese companies, however, have fewer than 5% 20,000 staff and therefore are only able to do deals 4% that are less than USD 20 million. 4% 3% M&A is considered by industry participants as the best 3% short cut to expand capacity and capabilities, and 3% 3% conventional wisdom suggests that downturns are a 66% 2% good time for M&A. However, the tightening of the 1% availability of credit and capital investment, as well as Beyondsoft Neusoft DHC uncertainties in the market outlook will likely deter M&A Insigma SinoCom Hyron activity in the software outsourcing sector for the Hisoft Achievo Others immediate short term future. Vanceinfo Chinasoft 8
  9. 9. China: Software Outsourcing Industry Solidiance examines the current market and implications for growth Conclusion on Market Player Structure What will likely happen 1. M&A initiatives in the future will likely come from 3. Unprofitable projects will no longer be accepted, as large listed companies, while M&A targets will they once were, when VC’s pressured companies to largely be companies that have qualified staff of grow clients, revenues and profits in anticipation of over 2,000 people. an IPO. 2. Small to medium players (less than 2,000 staff) will do their best to survive and be wary of expansion, especially since it will be hard to find financing. A dramatic change in the size of this segment is not expected. 9
  10. 10. China: Software Outsourcing Industry Solidiance examines the current market and implications for growth Seeking Gold in 2009 Domestic Market is Key for Growth in 2009 Manufacturing and Retail: 10% of the overall Chinese software outsourcing market belongs to the Telecom - 3G: Telecom historically is one of the most manufacturing and retail sectors, which have been important markets for software outsourcing. The severely affected by the drop in exports and global Chinese government announced that from 2009 consumption in 2009. As a result, greater emphasis has through 2010, USD 41 billion will be invested in 3G. The been placed on improving sales related operations. Ministry of Industry and Information Technology of Unless a software outsourcing project benefits sales estimates that this will contribute USD 2 – 3 billion of directly, these sectors will likely see less IT spend for growth to the software outsourcing industry. the foreseeable future. Energy: Traditionally, energy is another one of the E- Government: largest markets for software outsourcing. In February 2009, the Energy Bureau announced that USD 82 billion Mid-term: Due to a series of recent natural and human- will be spent in 2009 on the energy sector which will error tragedies such as mine explosions and speed the pace of nuclear and wind power development, earthquakes, China’s existing emergency and crisis entailing significant software application development. management systems were deemed outmoded and in dire need of upgrading. These events spur a major Transportation: Transportation is a strong focus in market opportunity for software outsourcing companies. the new USD 570 billion Chinese economic stimulus package. The Beijing government for example, will Short-term: Some successful e-government pilot- spend USD 20 billion (topped up by another USD 120 programs, such as an IT platform allowing the police to billion from the private sector) before 2010 to build four better serve their citizens, have been showcased as new subway lines. The investment brings opportunities projects that could easily be transferred to other cities for software outsourcing companies who are strong in nationwide, which offer good opportunities in the short developing transportation IT systems. term. Software Industry: China’s friendly Foreign Direct High Investment (FDI) policies, large talent pool and huge Telecom market potential have attracted many foreign software Energy companies to setup R&D centers in China. Microsoft Potential Transportation announced that starting in 2010, they will outsource Investment USD 400 million worth of R&D every year to China. Finance Software Amount Manufacturing Finance: In 2008, some 20% of outsourcing projects & Retail focused on the finance sector. The main customers in Low this segment came from the Japanese and US markets. Long Term Short term The current financial crisis has put heavy pressure to Timing develop better financial accountability tools for global players. 10
  11. 11. China: Software Outsourcing Industry Solidiance examines the current market and implications for growth Solidiance is a marketing and innovation strategy consulting firm with focus on growth in Asia Pacific. We are devoted to working side-by-side with our clients to outpace the competition, close gaps in growth and deliver breakthroughs in performance and profitability. Our Asia focus provides our clients with a better understanding of intrinsic regional issues. To subscribe to further white papers and to learn more about Solidiance please visit: Shutin Wah - Principal Allen Lee – Consultant Shutin Wah is a Principal based in the Solidiance Shanghai office with more than seven years of consulting experience. He has led over 50 national and multi-regional engagements Allen Lee is a consultant in the Shanghai office of Solidiance. for Fortune 500 clients across China, Hong Kong, and Prior to joining Solidiance, Allen worked for McKinsey & southeast Asia. Prior to joining Solidiance, Shutin managed Company, as well as two other international consulting the Shanghai operations of a global management companies in China. Subsequently, Allen started his own consultancy, establishing and managing client relationships. venture, advising international clients on market entry and With strong experience in combining numerical and product launch strategies in China for fine chemicals and qualitative analytics, Shutin specializes in customizing luxury goods. Allen has worked on engagements across a advanced market segmentation and size forecasting models variety of industries including Information technology, Oil & to help clients identify and prioritize market opportunities to Gas, industrial components, construction materials, retail and develop growth strategies. Shutin has rich experience across healthcare. Based on his previous experience, Allen focuses numerous growth sectors throughout China and Asia Pacific, not only on comprehensive analysis but also on developing including technology, engineering, and banking. He combines practical solutions jointly with clients to successfully navigate sector and cross-industry best practices, to leverage this Asia’s markets. Allen holds a Bachelor’s Degree in Finance knowledge to help clients develop successful market from Fudan University, Shanghai. strategies. He holds a Bachelor’s in Engineering from the Hong Kong University of Science and Technology and an MBA from the National University of Singapore. China Singapore Thailand Suite 801 Suite 17-01 Suite 32-05, Hong Kong Plaza High Street Center Interchange 21 283 Huaihai Road Central 1 North Bridge Road 399 Sukhumvit Road Shanghai 200021 Singapore 179094 Bangkok 10110 Tel: +86 21 5168 8905 Tel: +65 6408 8208 Tel: +66 (0)2 660 3638 11