While most software services companies graduated from Y2K to application development and e-business, some Indian companies like HCL Technologies, Wipro, Sasken and Mindtree were building competencies in niche areas for their clients. Pankaj Mishra studies Indian players in the R&D services market and finds that though volumes are rising, margin pressures have intensified

As Tier-One players drop prices G Venkatesh sees the pie for Tier-Two companies becoming smaller

The Indian R&D services story started when Texas Instruments (TI) established its development centre in Bangalore in 1985-86. At that time some Indian companies like Wipro and HCL began to execute R&D projects for TI. In fact, TI still outsources work to several Indian companies, including Wipro. Today, there are at least a dozen small players apart from Wipro, HCL, Hughes, Sasken and Mindtree who work in this space. R&D services outsourced to Indian companies include product development, embedded technology and chip design services. Earlier, such projects used to command premium rates and pressure on rate cuts was negligible. Alas, those days are gone, and clients have now begun to renegotiate with these companies.

Of late, many MNCs have started setting up offshore product development centres in the country. Older players, like TI and Intel who have been present for a long time, are enhancing their existing capacity and outsourcing more work to their Indian centres. Many Indian companies perceive this trend as an opportunity in disguise because the activity of MNC captive centres contributes towards positioning India as an R&D hub.

After the bloodbath in the global telecom space, a lot of Indian biggies saw their outsourcing opportunities evaporate. Telecom was the most lucrative source of revenue for most R&D players. Nortel, Cisco and AT&T used to outsource heavily—till the slump—after which they scaled down projects. On the demand side, the rise of core technology outsourcing can be attributed to the same factors that led to the growth of outsourced IT services. Secondly, customers are becoming increasingly aware that creating IP is the only way to stay competitive.
“Bringing the Offshore Development Centre (ODC) concept to R&D by Indian companies has brought down the value of what should be high-end work. In a bid to position themselves as cost-effective players, these companies have spoilt the market,” says Ramesh Emani, chief executive of embedded and access solutions at Wipro Techn-ologies. This has resulted in the ‘commodity pricing’ of R&D services.

Onsite rates have fallen from $68 to around $50 per manhour. Offshore rates have also come down to $22 for software R&D and $25 for hardware R&D work. Billing rates are expected to be flat for at least a year. Earlier, these rates used to appreciate by at least 10 percent annually.

“As people are getting laid off at large US telecom companies, these companies are increasingly looking at India with the intention of outsourcing, purely because of the cost-advantage. They are visiting India and negotiating hard,” says G Venkatesh, vice president at Sasken and also the head of the Semiconductor Business Division there. Analysts believe that the outsourced R&D market in India amounts to roughly $800 million to $1 billion a year and they expect it to reach $11 billion by 2008. North America, Western Europe, Japan, Korea and Taiwan have been traditional markets for R&D services.

Barring Wipro and HCL, none of the Indian players have end-to-end offerings in this space. Others like Sasken and Mindtree are domain experts in either a particular vertical (Sasken in telecom) or in a technology niche (Mindtree in IP creation). The industry has also seen consolidation in its client base. Till a year or so ago, Nortel, Lucent and Cisco were the largest clients for Indian players. Today, Nortel has vanished from that list, while Cisco still remains at the top, with HP emerging as the runner-up. Intel, Alcatel, Texas Instruments, Sony and others could potentially increase outsourcing.

The Tier-One–Tier-Two tug-of-war
Clients such as Cisco, HP, TI and Intel believe in having multiple outsourcing partners. These partners are a mix of Tier-One and Tier-Two players. Client visits, according to Sasken, have improved over the last few quarters. Other players still remain uncertain about the business environment.

With Tier-One players such as Wipro and HCL Technologies coming down to compete with niche players like Sasken, the premium attached to R&D services has vanished. Tier-Two companies have no choice but to remain focused on either a technology or an industry vertical. “We are focused on telecom and within that in wireless,” says Venkatesh. Thus, Tier-Two players are obviously chosen for their niche expertise. What was a demand-driven market almost a year back has now become bidding-oriented. Tier-One players have the scale and financial muscle to offer low rates which Tier-Two cannot.

“Our only handicap is the lack of scale for taking up large projects. However, we have started scaling up manpower for some of our accounts, but it will definitely take time to match the Tier-One players,” says S Janakiraman who is the CEO of Mindtree’s technology business. The company’s clients include Alcatel, Intel, Sony and Mitsubishi.
“The pie for Tier-Two companies is becoming smaller as Tier-One players drop their prices,” says Venkatesh.

The Chinese threat
Perceived by many industry observers as a threat to the Indian software services industry, the Chinese threat is more serious in the area of R&D services. On the supply side, Indian companies are pressurised by competition from low-cost destinations like China, Mexico, Russia and the Philippines.

“We are seeing China as a serious competitor in the R&D services outsourcing market. Owing to the large domestic hardware manufacturing base, Chinese companies are very strong in hardware R&D,” says Venkatesh. China is also one of the largest markets for telecom equipment manufacturers and they want to have their R&D base closer to the market. “One MNC telecom company is planning to scale down outsourcing to India and move projects to China,” reveals Emani.

Indian players also face stiff competition from captive India-based design centres of major clients. “Many new technology projects are coming to India because of MNC captive centres. This creates the right atmosphere for innovation, and the only way to leverage their presence is to partner with them,” says Emani. Almost 95 percent of Wipro’s R&D clients have an offshore base in the country.

“These MNCs are a short-term threat to us. In the long run, India stands to benefit. The local presence of these clients increases sub-contracting opportunities,” says Janakiraman.

After IT services (ITS) and IT-enabled services (ITES), related product and technology services for independent software vendors (ISVs) is a new opportunity for Indian companies according to the McKinsey 2002 report. Software product vendors like Autodesk are now outsourcing product development to third-party vendors. The market for these services is poised to grow rapidly and has the potential to become a $8-11 billion market by 2008, with a compounded annual growth rate (CAGR) of 20 to 40 percent, the report adds. Many leading global manufacturers such as Honeywell Industrial, Delphi, Rockwell Automation, Texas Instruments and Xerox have started leveraging India’s R&D services and capabilities, which has resulted in greater opportunities for Indian companies.

In the future, growth in this market will come from servicing software content in non-computing devices. 60 percent of the top ISVs like Novell, SAP, Cadence, i2, Adobe, Microsoft, Computer Associates, Veritas and Symantec have begun to leverage India for maintenance services and new product development. Further, growth in this area will be fuelled by the entry of focused third-party product shops, says the report.

Bottomline
The ongoing slump and fierce competition among Indian players has affected R&D outsourcing. The rate-war has left no room for premium pricing. To make matters worse, China is posing a serious threat to India in this space. The existence of a huge domestic manufacturing base in China has lured many MNCs into establishing an R&D base in that country. Of course, Indian companies can also tap China as a market by undertaking joint development work with Chinese companies.

With clients seeking more ‘ready-made’ offerings, IP creation is going to become lucrative. “IP creation is a better market to address now as MNCs seek to reduce investments in terms of time and money,” says Janakiraman.
Volumes will rise in the coming months as telecom companies resort to more lay-offs in the US. However, pressure on rates will also increase because the primary reason for offshore outsourcing is cost-effectiveness and not because Indian companies are perceived to be better in terms of the quality of work. India can also leverage the MNC offshore presence here by partnering with them to share technology and explore sub-contracting opportunities. This will help in demanding a premium when the slump bottoms out.