China: software outsourcing industry. implications for growth July 2009

Transcription

1 China: software outsourcing industry Solidiance examines the current market and Solidiance examines the current market and implications for growth July 2009

2 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 The Chinese software outsourcing industry will emerge more maturebytheendofthisyear. Dr.LiuJiRen BoardofDirectors,Neusoft 2

3 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 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 Many Victories, yet Many Challenges It all started in three cities - Dalian, Beijing, and Shanghai - in early 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 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 + Economic Storm = past 2 years), as well as rising human capital costs resulting from more restrictive labor laws in 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. 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. Uncertain Future 3

4 Market: To Grow or Not To Grow Drivers 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. 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. This trend creates a lucrative market for software outsourcing service providers. 4. Strengthening of the Japanese Yen improves margins earned by Chinese service providers. Exchange Rate (100 JPY Against RMB) 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. We have already seen some global clients shifting their outsourcing partnerships fromindiatochinaandthetrendwill no doubt continue. Ms.SunXinFang-CEOofChinasoft Neusoft s Margin vs JPY Exchange Rate JPY exchange rate Neusoft's margin 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% (The table above shows the relationship that Neusoft s margin rate increase when JPY appreciates and vise versa) Neusoft s Margin% 4

5 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 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 Solidiance interviews show the market expects growth to diminish further to around 7% in Reasons affecting growth for outsourcing include: Global CIOs are cutting IT budgets and renegotiating 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 Q 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. Of Beyondsoft s past clients, approximately 30% were unprofitable projects.wewerebackedbyvcsandin order to achieve high revenue, we accepted all projects, even small orders. Oftentimes the sales cost was already25%ofthepriceandtherewas very little room for margin. Mr.WangBin-CEOofBeyondsoft 5

6 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% moreworkforthesamefeeswecharged ayearago. Solidiance interview with an anonymous medium sized software company in China 6

7 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 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 bubble as companies took up unprofitable projects The Chinese market will keep growing, but the growth rate will declineto15%in2009andwillrecede furtherto10%in2010. Heiko Bugs- Director, Solidiance Expected depreciation of USD against RMB Market Size (USD Billion) China s Software Outsourcing Industry Market Size % 50% 40% 30% 20% 10% 0% Growth Rate (The table above shows that market growth will slow down in 2009 and 2010) 7

8 Market Player Structure What s Next During the growth period between , 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 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. China s Software Industry IPO Value 4,000 3,000 2,000 3, % 1, % 0% (The table above shows that China s software industry IPO total value decreased 91.2% in 2008 compare to 2007) World s Major Venture Capital s ROI 30% 25.10% -79.7% 20% 5.10% (The table above shows that world s major VC s ROI decreased 79.7% in 2008 compare to 2007) 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. Market Share in Terms of Off-shore Software Outsourcing Revenue Q % 5% 4% Neusoft Insigma Hisoft Vanceinfo 66% DHC SinoCom Achievo Chinasoft 4% 3% 3% 3% 3% 2% 1% Beyondsoft Hyron Others 8

9 Conclusion on Market Player Structure 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. 9

10 Seeking Gold in 2009 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. Transportation: 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. 10 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 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 humanerror 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 market opportunity for software outsourcing companies. High Potential Investment Amount Low Short-term: Some successful e-government pilotprograms, 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. Manufacturing & Retail Long Term Finance Telecom Energy Transportation Timing Software Short term

11 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 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 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. 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 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. China Suite 801 Hong Kong Plaza 283 Huaihai Road Central Shanghai Tel: Singapore Suite High Street Center 1 North Bridge Road Singapore Tel: Thailand Suite 32-05, Interchange Sukhumvit Road Bangkok Tel: +66 (0)