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