IT outsourcing firms struggle with increasing costs

China's information technology outsourcing providers are rushing to consolidate and adapt their marketing strategies, as they struggle to survive amid rising labor costs and competition from major multinationals.

Chinese ITO companies VanceInfo Technologies Inc and HiSoft Technology International Ltd announced in early August that they had signed an agreement under which the two companies will complete a tax-free, all-stock merger of equals with a combined equity of about $875 million.

According to the agreement, VanceInfo and HiSoft shareholders each will own about 50 percent of the joint venture, whose shares will continue to be listed on the Nasdaq Global Select Market.

The combined company is expected to have revenue in 2012 of more than $670 million, which would make it the largest China-based offshore IT services provider.

The merger is one example of how ITO companies are expanding their economies of scale, as they seek to stem the current profits decline in the industry, experts said.

Jin Yongqing, HiSoft software marketing director, said that since last year, some small service outsourcing companies began to see their profits drop because of rising labor costs and a lack of bargaining power compared with behemoths like Microsoft Corp, IBM Corp and Huawei Technologies Co Ltd.

Currently, China has more than 16,000 software outsourcing companies, most of which are small, with a production value of less than $100 million.

Data from the Ministry of Industry and Information Technology show that China's software industry saw revenues of 1.10 trillion yuan ($173 billion) in the first half of the year, up 26.2 percent from a year earlier.

Industry profits totaled $117 billion yuan for the first six months, increasing by 10.6 percent, 24.6 percentage points lower than that of the same period last year.

Market research data from China International Capital Corp Ltd show that after salary increases of 115 percent in 2011, the average labor cost of ITO industry rose 5 to 7 percent in 2012, resulting in a profit drop for most ITO companies.

The company said labor costs usually account for 60 to 70 percent of ITO providers' total costs. ITO providers' profits decreased 1.5 to 2 percent with every 5 percent increase in labor cost.

Competing fiercely on price, ITO companies can't transfer labor-cost increases to their buyers, and also have to shoulder surging production costs that lead to shrinking profits, according to the research.

"The era when ITO providers made profits through the low cost of software engineers has gone, and we should promote a business model that will keep the company profitable," said Liu Jiren, Neusoft Corp CEO.

As China's second-largest ITO provider, Neusoft is establishing its cloud computing platform, which will be used on its service outsourcing business.

"Neusoft is planning to establish its health-industry zone in Shenyang city; developing businesses including research and development of medical equipment, health management and service; and forming a new business sector combining the Internet and health services," Neusoft Vice-President Lu Xiaoxia said.

Another Chinese IT service provider, iSoftStone, is also focusing on business diversity and expansion.

"Compared with merger and acquisition activity, which may cost a lot in terms of human resource integration, iSoftStone prefers concentrating on expanding its business to finance, urban development and telecommunications to maintain stable growth and reduce the effect of surging production costs," said Wang Li, senior vice-president of iSoftstone.

Since 2011, the telecom equipment manufacturer Huawei has planned to establish joint ventures with its IT service providers iSoftstone, VanceInfo and ChinaSoft International Corp, setting its foothold on the IT outsourcing industry.

ChinaSoft announced in January its plans to set up a joint venture with Huawei, in which ChinaSoft will have a 60 percent stake and Huawei owns the rest.

"The merger with Huawei will help us learn a lot about IT service buying, through which ChinaSoft can integrate our IT resources and improve comprehensive competitiveness," ChinaSoft said in a statement.