Project watch - Chinese outsourcing on the rise

2nd April 2007

By Patrick Wachter

With its low-cost, high-skilled and plentiful labour force, China has been working hard in recent years to put itself on the map as a viable offshore destination for IT services work. Patrick Wachter investigates.

While the largest of the Chinese offshore suppliers have posted remarkable growth numbers recently, their efforts on the whole have been overshadowed by the bigger outsourcers that lie to the south, in India. Here the top suppliers have enjoyed an earlier start in the global outsourcing market and a larger geographic reach in terms of both operations and customers.

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Chinese firms, on the other hand, are still mostly working on the lower end of the services ladder - basic applications, software testing and some R&D - mostly for multinational companies' Chinese operations, not their wider IT concerns.

But even if their outsourcing model is not as evolved as their Indian counterparts, Chinese companies are positioning themselves for further growth and more sophisticated project work. Many have established good relationships with software and high-tech companies, doing a lot of the product development and testing required before a company such as Microsoft or Oracle releases its latest software. Some are beginning to move up to services such as package implementation or infrastructure management. A few companies have established their headquarters and front-end sales offices in the US or Europe, while keeping their back-end operations in China, to capture more contract opportunities with Western clients.

The Chinese offshore outsourcing market stood at $1.4bn in 2006, according to the latest figures from CCID Consulting, an analyst group sponsored by the Chinese government that focuses on the country's IT sector. The market should grow between 45% and 50% on a compounded annual basis, according to Li Jun, CEO of CCID.

But the geographic breakdown of offshore customers is heavily concentrated in Japan, and to a lesser extent, Korea. "These markets account for nearly 60% of the Chinese offshore business," Li says. "Most of the Chinese vendors are starting with low-end services, such as software testing and foreign product localisation. But now, particularly in the Japanese financial services sector, they're moving on to application development."

The Japanese offshoring market is not nearly as mature as that of the US or Europe, but China seems to have found one of the keys. The northeastern Chinese city of Dalian, formerly a Japanese colony, is home to a substantial Japanese-speaking population, and has become a hub for software outsourcing to Japan. The Dalian government offers enticing tax incentives to businesses, and several Japanese technology firms have set up support operations in the city. Plus mega-outsourcers such as IBM, HP and Accenture have each opened delivery centres in Dalian with an eye toward the Japanese market.

Apart from Japan and Korea, the US is the destination of about 20% of Chinese offshore services, and the remaining 20% is scattered around the globe, Li says.

The offshore service mix remains tilted toward lower-end services, Li adds. In 2006, system testing and software localisation - where a Chinese vendor adapts a software product for the Chinese market and language - together made up more than 50% of the total $1.4bn in offshore services. Application development was responsible for another 40% of the market, Li says. Despite China having roughly twice as many engineering graduates each year, there is a lack of experience in the Chinese IT sector.

This means it is hard for Chinese outsourcers to assemble properly qualified teams for high-value consulting and implementation work.

Of the major Chinese players, Li says the biggest is Neusoft Group, a provider of software and services as well as medical technologies. Overall the company employs more than 10,000 staff, and about 7,000 of those are now dedicated to the software and services business, up from 4,000 at the start of 2006, Li says. "Still this is relatively small, especially when compared with the Indian companies," Li says, but the key for Chinese suppliers is growth rates, and there are several Chinese vendors that doubled their revenue in 2006.

Neusoft sees most of its revenue from domestic software and services sales. According to Walter Fang, Neusoft's CTO, the company posted about $33m in offshore revenue in 2004 and more than $60m last year, but this is still only a minor portion of the company's total revenue, which hit $350m in 2005. "We're trying to increase our offshore portion, and it has been growing at pace with the overall Chinese offshore market, maybe a little faster," Fang says. "One of the top reasons for outsourcing to China these days is that companies in the US or Japan are trying to align their target overseas markets with their outsourcing destination."

That means companies like Motorola and Nokia, eager to tap China's enormous consumer market, need outsourced services to support their Chinese strategies, Fang says. On the software side, SAP and Neusoft last year announced a partnership through which SAP received a minority stake in the company and would provide training to expand Neusoft's SAP offerings.

"These technology companies are looking for skills in China. Cost savings are still a factor, but there simply aren't enough well trained engineers," Fang says. "This is especially true in embedded software for hardware devices and product development."

But Neusoft's clients are also content to send the basic software testing and quality assurance work to China, and Fang says the cost of these is still attractive compared to India. Thus much of China's work remains on the product development side, instead of actually providing services for companies' internal IT departments.

Fellow Chinese outsourcer Worksoft Creative Software Technology derives about 70% of its revenue from R&D and product services, according to David Chen, the company's COO. Worksoft provides application development, quality assurance, testing and localisation services for big names such as IBM, Oracle and Microsoft, its largest client.

Chen says the company entered the IT services space - as opposed to its main R&D business - about two or three years ago, and this area now accounts for the other 30% of sales. He says Worksoft competes with notable Indian vendors such as TCS and Infosys for application development and package implementation. It is a tough field, but the company has had some success, beating out Infosys, for example, on a Seibel implementation project for Motorola.

Worksoft focuses on the financial services and manufacturing/retail verticals, both areas in which large multinationals such as Citibank, HSBC, and Wal-Mart are setting up operations in China. Indeed much of the company's work is supporting Chinese or broader Asia-Pacific operations for these type of companies. And although domestic support for global firms takes place in China, Chen says that 90% of Worksoft's customers are based in the US or Europe, with the other 10% in China or Japan.

Worksoft's offshore capabilities have attracted investments from Legend Capital, Doll Capital Management and Sequoia Capital, its largest shareholder. According to Chen, the company is planning a US IPO in the next 18 months and will use the proceeds to build up its infrastructure, potentially acquire other firms, and partner with other vendors. Chen was unable to disclose any revenue figures, but headcount stands at 2,600, and he sees that number increasing to between 4,000 and 5,000 by the end of the year, suggesting an impressive growth rate and solidifying the company's place as a top Chinese services outfit.

Much like Worksoft, Acheivo hopes to increase its global reach and service portfolio. The company, which is based outside of San Francisco but relies on its back-end squad of programmers and engineers in China, has been busy in the past two years acquiring additional delivery resources in China and more client-facing consulting and sales teams in the US, Japan and Europe.

"We'll probably slow down the acquisitions a bit in 2007, but there maybe a few more in the coming months," says Robert Lee, Achievo's chairman and CEO. He said the company today predominantly handles software development and testing-related areas for a combination of software vendors, for whom it provides product work, and a range of companies across several sectors, for whom it offers internal application services.

"We now have the critical mass to take on most development projects," Lee says. "We're probably the only main Chinese outsourcer with a global presence, and our local front-end has played out very well. We're practically hiring people as fast as we can."

Achievo last year achieved CMMI-5 certification, becoming "one of a very few, maybe five" Chinese firms to reach that level, Lee says. Neusoft, for example, received its certification in late 2004.

Lee puts Achievo's current headcount at about 1,600 employees, with a target of close to 2,500 by the end of the year. He says the company is organically growing at about 40%, which is roughly in line with the overall Chinese offshore growth trajectory. But factoring in Achievo's acquisitions, its growth rate is even higher.

Some 95% of Achievo's revenue comes from outside China, which Lee says helps differentiate it from many of the other Chinese suppliers. "In China there are several different segments of outsourcers. The Chinese-based companies have some non-China business from Japan. Within China, some are doing business with multinationals such as IBM and Siemens, but these are still Chinese clients. The vendors are still paid in Chinese currency."

Competitively, Lee says Achievo's position has not changed too much in the past few years. "We don't run into a lot of Chinese companies outside of China, except in Japan. But even there, demand is so high that it's a matter of hiring people quickly enough," he says.

Even with the different types of Chinese outsourcing models - China-based with a big domestic focus, Chinese-based with a bigger offshore component, and non-China-based with an almost pure offshore focus - Lee says there are a relatively small handful of strong vendors. "Eventually, only a handful will be left with the financial depth and operational scope to win the bigger deals."

CCID's Li does not see many mergers taking place in the outsourcing space right now, and he expects consolidation to take another two to three years to finally kick in. "We'll see it then, and there might be the possibility of Indian and US-based buyers moving in," he says. "But these [Chinese] companies are growing very fast and they have their own sales channels. There's no urgent need for them to be bought."

Go West: Chinese companies making an impact overseas Chinese outsourcing

Chinese outsourcing company hiSoft Technology bought US-based Envisage Solutions last month to boost its presence in the US and European outsourcing markets, as Chinese firms began to flex their muscles in Western markets.

The acquisition followed that of UK customer relationship management software company Respond Group by Chinese applications and IT services vendor CDC.

CDC has been in acquisitive mood recently, snapping up US-based vertically oriented services provider Vis.align in December, as well as UK-based food and beverage, pharmaceuticals and chemicals specialist MVI in October.

CDC also tried and failed to acquire US CRM vendor Onyx software in 2006 after its unsolicited offer was rejected.

Respond's software is designed to manage complaints and enterprise feedback, and CDC said it fits well with its own Pivotal CRM solutions. Respond has an installed base of about 800 customers including AXA Insurance, Barclays and Aegon.

Meanwhile, hiSoft target Envisage provides Siebel consulting services in business intelligence, CRM and web services. Besides giving hiSoft, which previously saw most of its revenue from Japan, a better client base in the US and Europe, the Envisage deal brings some higher-value consulting services to the company.

CBR Opinion

China's position as a booming consumer market and a global manufacturing and technology developmer will ensure there will plenty of entry-level testing and localisation services for Chinese outsourcers. The growing Chinese domestic market will also provide ample opportunities for even the smaller Chinese software shops. But eventually consolidation and the need to scale will whittle down the field of top outsourcing providers in China. Those companies that can maintain their domestic and Japanese revenues, while successfully pursuing European and US deals will have the natural advantage. The domestic infrastructure is in place; hiring the right type of top talent will be key. As with the Indian companies, the best Chinese outsourcers will gradually incorporate more advanced applications, integration and infrastructure services into their offerings. Some will likely develop strong embedded software capabilities to work with makers of mobile phones and other hardware devices. And while any serious acquisition moves from a big global service player are probably years away, there is a decent strategic case to be made by these companies for scooping up one of the Chinese outfits to boost their presence in the region and diversify their offshore delivery.