china software outsourcing industry -

China: software

outsourcing industry

Solidiance examines the current market and Solidiance examines the current market and implications for growth

July 2009

China: Software Outsourcing IndustrySolidiance examines the current market and implications for growth

“The software outsourcing industry is a symbol ofChina’s great leap forward from a focus on industry toservice. In less than five years, China, by leveraging itslow-cost labor and driven by government ambition, hasbecome one of the most important softwareoutsourcing destinations in Asia.

Unfortunately, the global economic slump, theappreciating RMB, and new labor laws in 2008 havestarted to curb growth in this previously soaring sector.For the first time, companies in this sector areexperiencing declining orders, tougher contractualterms, and the need to re-configure their talent pool tomeet irregular market demand.

In light of current changes, this paper presents ourviews on the road ahead for China’s softwareoutsourcing industry, its challenges and opportunities.

Even in the current downturn, weare expecting margins to increaseat least 20% in 2009... TheChinese software outsourcingindustry will emerge moremature by the end of this year.

Dr. Liu Ji Ren – Board of Directors, Neusoft

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past 2 years), as well as rising human capital costsresulting from more restrictive labor laws in 2008.

This fast growth created a fragmented market withmany small and medium size players. There were over8,000 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 expectedto consolidate down to 3,000 over the next two years,through both competitive elimination as well aspotential mergers and acquisitions (M&A). This hasbeen cited as a positive advancement for the Chinesesoftware outsourcing industry, because the remaining,stronger players will be those with a better chance tocompete for higher value outsourcing deals currentlyserved by Indian outsourcing companies.

When Healthy Growth Meets Economic Storm

A Giant Leap

China’s software outsourcing industry achieved animpressive growth rate of 38% year-on-year from 2004to 2008. Driven by strong government support, activeinvolvement from venture capitalists, and growing ITbudgets from clients experimenting with new hi-techproductivity tools, the Chinese market size for softwareoutsourcing reached USD 2.6 billion in 2008.

Many Victories, yet Many Challenges

It all started in three cities - Dalian, Beijing, andShanghai - in early 2003. Having seen encouragingsuccess, the China State Council offered incentives togrow the sector. As of Feb 2009, there were 20 citiesdesignated as ‘window cities’ to house software

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served by Indian outsourcing companies.

However, another challenge faced by the sector amidthe economic slump is a drop in large value orders.Over the past six months, the industry has seen fewerUSD 10 million orders, yet it is still under pressure tomaintain the staffing levels set during recent boomyears. Firms are starting to question when they will seethese multi-million dollar deals again, and in spite of thespending downturn and consolidation among peers,what steps should be taken to facilitate survival andfuture growth.

=

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designated as ‘window cities’ to house softwareoutsourcing companies.

An important development over the past five years wasthe gradual movement from low-value outsourcing work,typically the result of multiple layers of sub-contracting,towards mid-end outsourcing work, involving greaterlevels of consultation and design. This was driven bythe improving technical competence of Chineseoutsourcing providers, the rising pressure on marginsfor low-end work resulting from Renminbi (RMB)appreciation (RMB appreciated 15% against USD in the

Uncertain FutureEconomic Storm


Market Growth Drivers for China’s SoftwareOutsourcing Industry

1.Transfer of outsourcing business from India.

Some recent events have damagedIndia’s credibility as the world’s top choice for softwareoutsourcing. For example:

– The December 2008 terrorist assault in Mumbai.– The billion dollar accounting scandal at Satyam, India’s4th largest software outsourcing company.−World Bank’s blacklisting of Wipro, India’s 3rd largestsoftware outsourcing company.

2.Chinese government’s support of the softwareoutsourcing industry.

This trend creates a lucrative market for softwareoutsourcing service providers.

4. Strengthening of the Japanese Yen improves marginsearned by Chinese service providers.

Approximately 50% of China’s software outsourcingbusiness comes from Japan and contracts are mainlysigned in the Japanese Yen currency (JPY). The chartabove shows that the appreciation of JPY will lead tohigher revenues and margins for Chinese softwareoutsourcing companies. The strong JPY trend of thefirst quarter 2009 will benefit the profitability of China’ssoftware 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 cuteffective February 2009, until the end of 2013, foroutsourcing companies. This incentive allows more roomfor outsourcing companies to learn to survive andcompete.−The economic stimulus package will also supportindustries such as telecom and energy, which are keycustomers of China’s software outsourcing industry.

3.The growing need for unified software and processes inChina.

The integration of Chinese companiesinto the global business arena and rising M&A activitiesincreases the need for unified software and processes.Within the first two months of 2009, Chinese companiesspent USD 21.8 billion acquiring international companies,a 40% increase year-to-year. Now Chinese multinationalcorporations (MNCs) face the challenge of integrating andconsolidating supply chains, logistics, informationtechnology and human resources, among other functions.

Neusoft’s Margin vs JPY Exchange RateExchange Rate (100 JPY Against RMB)

JPY exchange rate Neusoft's margin

Neusoft’s Margin%

(The table above shows the relationship that Neusoft’s margin rate increase when JPY appreciates and vise versa)

5.86.06.26.46.66.87.07.27.47.6

0%5%10%15%20%25%30%35%40%45%

We have already seen some global clientsshifting their outsourcing partnershipsfrom India to China and the trend willno doubt continue.

Ms. Sun Xin Fang - CEO of Chinasoft

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Market Growth Barriers for China’s SoftwareOutsourcing Industry

1.Global economic downturn.

The global software outsourcing industryas a whole is affected by the current economic slump. InIndia for example, which holds approximately 40% of theglobal software outsourcing market, the market is stillgrowing 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 expectsgrowth to diminish further to around 7% in 2009.Reasons affecting growth for outsourcing include:

−Global CIOs are cutting IT budgets and renegotiatingcontract 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 unprofitableprojects. We were backed by VCs and inorder to achieve high revenue, weaccepted all projects, even smallorders. Oftentimes the sales cost wasalready 25% of the price and there wasvery little room for margin.

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”contract terms – in many cases a lower price for thesame amount of work.

−Outsourcing decisions are being delayed or canceled,which will affect the volume of contracts sold in Q1 andQ2 2009.

Historically, companies would consider outsourcingtowards the end of a market downturn. Recent Solidianceinterviews show it could take even longer this time as theoverall investment sentiment has dropped significantly.Executives are cautiously handling their outsourcingbudgets and will hold back investments until they see asustainable economic recovery.

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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 outsourcingindustry was fueled by venture capital (VC) investmentand initial public offerings (IPOs), and the mainmeasurement for success was turnover, not profit. Asa result, companies accepted all types of projects,including non-profitable ones, to boost revenue growthand client count. Now that labor costs are increasingand IPO listings are less likely to materialize,outsourcers are re-examining their portfolio and will beless inclined to accept projects that may appearunprofitable, thus reducing growth.

We started to feel the heat of theeconomic downturn several monthsago. Customers started to demand 25%more work for the same fees we chargeda year ago.

Solidiance interview with an anonymous medium sizedsoftware company in China

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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 keepgrowing, but the growth rate willdecline to 15% in 2009 and will recedefurther to 10% in 2010.

Heiko Bugs - Director, Solidiance

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(The table above shows that market growth will slow down in 2009 and 2010)

Market Size (USD Billion)

Growth Rate

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

3.03.3

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%

”

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During the growth period between 2004 – 2007, highgrowth potential attracted numerous VCs, includingGranite Global Ventures and Tiger Fund, to putsignificant investment into China’s software outsourcingindustry. This helped companies to grow quickly andlaunch their IPO. This growth model ended with theadvent of the current financial crisis.

In 2009, major drops in the global stock markets haveresulted in low returns on investment (ROI).Furthermore, IPO activity has all but dried-up. Thistrend means other financing channels are needed.Listed companies such as Neusoft and Vanceinfo, havean advantage since they are well capitalized. They alsohave the option to issue new shares, which would fundthem to acquire additional resources from small to The chart below shows the level of fragmentation of the

-91.2%3,250

2860

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

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them to acquire additional resources from small tomedium-size companies that are in financial distress.

The most important strategic imperative for thesoftware outsourcing industry is expansion. The size ofa company’s work force (along with its educational level,efficiency, and experience) is the measure of the abilityto do large software outsourcing deals. Top Indiancompanies with staff of over 100,000 people have thecapability of doing deals worth over USD 100 million.Top Chinese companies, however, have fewer than20,000 staff and therefore are only able to do dealsthat are less than USD 20 million.

M&A is considered by industry participants as the bestshort cut to expand capacity and capabilities, andconventional wisdom suggests that downturns are agood time for M&A. However, the tightening of theavailability of credit and capital investment, as well asuncertainties in the market outlook will likely deter M&Aactivity in the software outsourcing sector for theimmediate short term future.

The chart below shows the level of fragmentation of theChinese software outsourcing industry. The small andmedium sized players that are cash-tight will struggle tosurvive through the current economic downturn, whilethe larger players with a bigger pool of well-trained andexperienced staff, will continue to capture more of thepie.

7%5%

4%

4%

3%

3%

3%3%

2%1%

66%

NeusoftInsigmaHisoft

Vanceinfo

DHCSinoCom

AchievoChinasoft

BeyondsoftHyronOthers

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 fromlarge listed companies, while M&A targets willlargely be companies that have qualified staff ofover 2,000 people.

2. Small to medium players (less than 2,000 staff)will do their best to survive and be wary ofexpansion, especially since it will be hard to findfinancing. A dramatic change in the size of thissegment is not expected.

3. Unprofitable projects will no longer be accepted, asthey once were, when VC’s pressured companies togrow clients, revenues and profits in anticipation ofan IPO.

Conclusion on Market Player Structure

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Domestic Market is Key for Growth in 2009

Telecom - 3G: Telecom historically is one of the mostimportant markets for software outsourcing. TheChinese government announced that from 2009through 2010, USD 41 billion will be invested in 3G. TheMinistry of Industry and Information Technology ofestimates that this will contribute USD 2 – 3 billion ofgrowth to the software outsourcing industry.

Energy: Traditionally, energy is another one of thelargest markets for software outsourcing. In February2009, the Energy Bureau announced that USD 82 billionwill be spent in 2009 on the energy sector which willspeed the pace of nuclear and wind power development,entailing significant software application development.

Manufacturing and Retail: 10% of the overallChinese software outsourcing market belongs to themanufacturing and retail sectors, which have beenseverely affected by the drop in exports and globalconsumption in 2009. As a result, greater emphasis hasbeen placed on improving sales related operations.Unless a software outsourcing project benefits salesdirectly, these sectors will likely see less IT spend forthe foreseeable future.

E- Government:

Mid-term: Due to a series of recent natural and human-error tragedies such as mine explosions andearthquakes, China’s existing emergency and crisismanagement systems were deemed outmoded and indire need of upgrading. These events spur a major

Seeking Gold in 2009

High

Low

Short termLong Term

Potential

Investment

Amount

Timing

Telecom

Energy

Transportation

Manufacturing

& Retail

SoftwareFinance

Transportation: Transportation is a strong focus inthe new USD 570 billion Chinese economic stimuluspackage. The Beijing government for example, willspend USD 20 billion (topped up by another USD 120billion from the private sector) before 2010 to build fournew subway lines. The investment brings opportunitiesfor software outsourcing companies who are strong indeveloping transportation IT systems.

Software Industry: China’s friendly Foreign DirectInvestment (FDI) policies, large talent pool and hugemarket potential have attracted many foreign softwarecompanies to setup R&D centers in China. Microsoftannounced that starting in 2010, they will outsourceUSD 400 million worth of R&D every year to China.

Finance: In 2008, some 20% of outsourcing projectsfocused on the finance sector. The main customers inthis segment came from the Japanese and US markets.The current financial crisis has put heavy pressure todevelop better financial accountability tools for globalplayers.

dire need of upgrading. These events spur a majormarket opportunity for software outsourcing companies.

Short-term: Some successful e-government pilot-programs, such as an IT platform allowing the police tobetter serve their citizens, have been showcased asprojects that could easily be transferred to other citiesnationwide, which offer good opportunities in the shortterm.

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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 tooutpace the competition, close gaps in growth and deliver breakthroughs in performance and profitability. Our Asia focus provides our clients with a betterunderstanding 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 17-01High Street Center1 North Bridge RoadSingapore 179094Tel: +65 6408 8208

Singapore

Suite 801Hong Kong Plaza283 Huaihai Road CentralShanghai 200021Tel: +86 21 5168 8905

China

Suite 32-05, Interchange 21399 Sukhumvit RoadBangkok 10110Tel: +66 (0)2 660 3638

Thailand

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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.

china software outsourcing industry -

Business

house software

indian outsourcing companies

lowvalue outsourcing

higher value outsourcing

current market andimplications

fast growth

chinese market size

current downturn