Vance Info Master File — Jan 2011
Pre-determined game plan – Jan 2011
** Working Thesis: VanceInfo Tech, an IT solutions and software development company in China, will benefit as (a) the crisis to Do More With Less drives more and more outsourcing generally and as (b) the institutional imperative for CIOs to “have a China plan” intensifies over the next few years as the country establishes itself as the economic engine of the planet. Competitively, VanceInfo is well run and will leverage its early well-established position to take advantage of this extremely attractive NODE #2 market opportunity. Conviction: Medium.
** Burning Questions (Jan 2011)
- LOCAL USER CRISIS: What are the specific drivers driving *local* customers to outsource to VanceInfo and are they sustainable? Do More With Less? Enablement? Lack of in-house expertise?
- USE CASES: When VanceInfo wins multi-national work, why isn’t *that* competed with Indian firms?
- BACKGROUND: What drives the founders and top management … and how did they get in this position to break out from the crowd in China?
- MANAGEMENT: Can this company handle hyper-growth and an expanding customer base?
- TREND-LINE GROWTH: Was growth of 44% in 2009 and 42% in 2010E a function of actual end user demand or available supply / capacity? Why was growth not 60%? …. or 25%?
- EBIT MARGIN: What is the company’s long-term EBIT margin target?
- TPPA: Will VanceInfo’s growing size meaningfully lower the TPPA for prospective customers?
** Where the Thesis Will Be Wrong (Jan 2011)
- MACRO: If growth stalls in China.
- CUSTOMER CONCENTRATION: Does this undermine the idea of a massive, wide NODE #2 market?
- STUBBORN TPPA’S: Some TPPA’s don’t dissolve fast enough to drive more outsourcing from abroad. Security. Intellectual property. Politics.
- NODE #3: An extremely fragmented competitive landscape prevents VanceInfo from breaking out from the crowd.
- WAGE INFLATION: Will wage increases stay in check?
FOUR NODE CONSIDERATIONS
NODE #1 – SOCIETAL SHIFT
Positive. VanceInfo will benefit from Outsource It, Globalization, and Do More With Less.
** GLOBALIZATION: Technology has supported the so-called shrinking of the planet; geography and nationality
have become less of a barrier. Key words that we associate with globalization are *effective*, *expanded sourcing
pool* and *expanded market opportunity*. For example, those who are using or facilitating the expanded global
sourcing pool will benefit while those who do not will face a diminishing competitive advantage.
** DO MORE WITH LESS: The old way of thinking about Enterprise spending was: “technology is critical to
competing in the future. IT will save you.” The new way of thinking is: Do More With Less.” We see no signs of
a reversion to the prior “mantra” and we do not expect as such. Public companies have exhibited tendencies of
being addicted to margins and outsourcing is one form of pursuing that addiction. There is a huge and on going
opportunity in understanding the “Do More with Less” mantra and then tailoring and selling services and products
successfully into such an environment.
** OUTSOURCE IT: Although the concept is hardly new in its effect, the word “outsourcing” has become
prominent in the last 2 decades. Today, peer pressure to outsource is immense; keeping fixed costs down is at a
premium; shrinking down to one’s core competency is growing. Those abstracts are manifesting themselves in a still
rapidly growing set of business opportunities.
NODE #2 – MARKET OPPORTUNITY
Very positive. We suspect we are in the very early stages of a long runway of growth for the Chinese IT outsourcing industry. The market opportunity is plenty large for VanceInfo to grow into. The bigger considerations we have involve assessing the users’ crisis / total perceived pains of adoption (TPPA) to gauge how rapidly VanceInfo can penetrate this market.
First – the market size. According to IDC, in 2009 the total China-based IT Services market size is estimated to have grown to $13.4bn from $9.7bn in 2007 and is expected to grow at a CAGR of 17% from 2007 to reach $25bn by 2013. Of this $25bn, Domestic IT services are expected to grow to $18.2bn in 2013 from $7.7bn in 2007 while Offshore IT outsourcing is expected to grow to $6.8bn in 2013 from $2.7bn in 2009.
According to the MIIT, the Chinese software development market represents ~8% of the global market, but should double its share by 2013.
Final data point for context, from KPMG: In China 10% of all IT is outsourced. KPMG says the US is more like 30%. The point: IT outsourcing is very early in China, but it’s growing.
At any rate, we take all the 3rd party consultant forecasts – and the MIIT projection – with a grain of salt, but the point is that inside of a global IT sourcing market that is $500bn, there is ample room for a company whose 2010 revenues will be just north of $200mn to grow.
The bigger NODE #2 question we have: will customers spend more on *China’s* IT sourcing companies?
We suspect so. First off, the majority of VanceInfo’s growth is being driven by outsourcing from local Chinese companies. So, they happen to be selling to a very dynamic, growing customer base.
Second, as far as outsourcing by multi-nationals *to* China goes, we see a Change Function that will increasingly go in VanceInfo’s favor:
- The crisis to Do More With Less will only intensify, and the pressure for CIO’s to have a “China strategy” will only grow.
- In today’s “Globalized” world, some of the TPPA’s that may have prevented a CIO from outsourcing to China … say … five years ago are falling. Example: the management teams of most of the leading Chinese outsourcing companies have studied in the West. Cultural – and language – gaps are narrowing.
Some other key NODE #2 characteristics:
- 56% of revenues from the top five customers (Microsoft, Huawei, Expedia, Citigroup, and TIBCO). Below, we mention strong reference accounts as providing some power in NODE #3.
- Revenues from China: 45% of revenues, up from 11% in 2007.
- Revenues from the US: has fallen from 70% of revenues in 2007 to 35%.
Here’s a quick view of the mix of services Vance offers. The point: R&D services makes up a large % of revenues. So, this isn’t a direct comp of India & the app maintenance / development that is prevalent there. In our master file, we include some specific examples of services that fall under each of these segments.
- R&D Outsourcing: 63% of revenue.
o R&D Services: 62% of overall revenues.
o Globalization & Localization: < 2% of overall revenues.
- IT Services: 34% of revenue.
o Enterprise Solutions: 10% of total revenues
o App development & maintenance: 19% of total revenue
o Quality Assurance & testing: 5% of total revenue.
- Other: 2% of revenue. (BPO & System Integration).
NODE #3 – COMPETITIVE LANDSCAPE
Positive bias, but many of our burning questions reside here in NODE #3.
The context here: Conviction that there is something *unique* about VanceInfo that others simply can’t match in China: Low. But, conviction that the company is very well run and that it will leverage the leading position it has established to take advantage of this extremely attractive NODE #2 market: High.
Our master file has more detail about who participates here, but the key takeaways about VanceInfo’s competitive landscape:
- It is *extremely* fragmented. As part of the government’s push to grow the IT services market in China, it has a goal to create – literally – 1000 companies in the country.
- Thus far, the top companies have distinguished themselves by developing expertise in one particular market, vertical, or region. Typically, not *all* major participants compete for the same RFPs.
- VanceInfo considers its core competency to be (a) quality work, (b) good reference accounts, and (c) a very responsive management team – traits that we will be working to deepen our knowledge about but that are consistent with what we’ve seen from the company thus far.
We suspect the good reference accounts count for a good bit and that as VanceInfo grows in size & scope, its reputation / brand will likely strengthen relative to other local Chinese competitors. Additionally, as far as competition from multi-nationals goes, we suspect the software & services industry in China will have similar characteristics as other markets in China in that it will be extremely difficult for non-Chinese competitors to enter and compete effectively.
NODE #4 – FINANCIAL LEVERAGE
VanceInfo’s NODE #4 model is characterized by rapid top line growth, relatively steady EBIT margins, and estimates which have been steadily rising over the past 12mo’s.
** Headline estimates: 2008 to 2012E
- Revenue Growth: 64%, 44%, 42%, 28%, 29%
- EBIT Margin GAAP: 14%, 15%, 16%, 16%, 16%
- EBIT Margin Non-GAAP: 17%, 18%, 17%, 18%, 18%
- EPS: $0.45, $0.60, $0.80, $0.97, $1.23
- Valuation: 36x 2011 EPS
** Decision Engine: Using the following assumptions, we get a DCF value that is roughly equal to the company’s enterprise value: $1.5bn. This puts Vance in the 3rd quintile.
- Mid-term growth: 16%
- EBIT margin: 18%
- Tax rate: 12%
- Terminal: 4%, WACC: 10%
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QUICK LOOK
VanceInfo Technologies (Ticker: VIT); $ 1 Bn Market Cap; Software
***What is the PROMISE:
Vance Infos promise is to provide top quality software development and outsourcing services with local Chinese expertise for lower costs than larger global competitors.
***** Description:
VanceInfo Technologies Inc. is an information technology solutions and software development company. The Company's services include research and development enterprise solutions, application development and maintenance, quality assurance and testing, as well as globalization and localization. Source: Bloomberg
***** Rev Split what they do:
R&D Outsourcing 65%
IT Services 32%
Other 3%
****What is the Change?
Vance Info is taking share in Asia and abroad due to lower wages than competitors.
*****Operating Model
Revenue growth: 2007-2012E:
116%, 64%, 44%, 37%, 25%, 38%
EBIT margin: 2007-2012E
13%, 14%,14%, 16%, 16%, 16%
***** 4 Steps:
** Node 1: What is the cultural change?
*Outsource It!
*Globalization & China
** Node 2: Is there a monstrous & growing market?
According to IDC, in 2009 the total China-based IT Services market size is estimated to have grown to $13.4 bln from $9.7 bln in 2007, and is expected to grow at a CAGR of 17% from 2007 to reach $25 bln by 2013. Domestic IT services are expected to grow to $18.2 bln in 2013 from $7.7 bln in 2007, at a CAGR of 15.5%.
The Chinese Offshore IT outsourcing market has expanded at a 35% CAGR from 2004 to 2009, reaching $2.7 bln in 2009. The Chinese Ministry of Information Technology (MIIT) expects this market to grow at a 23% CAGR to $6.8bn in 2013.
According to the MIIT, the Chinese software development market represents ~8% of the global market, but should double its share by 2013.
In recent years, the US and Europe have passed Japan and Korea as the largest buyers of Chinese IT exports.
What is providing the fuel for this market growth is Chinas 5 year plans. In the 11th Five-Year Plan, which established economic direction for 2006-2010, the Chinese government made software and IT-related service a target industry launched policies to encourage multinational corporations to transfer outsourcing business to China. The government established special funds to build public information platforms, cultivate talent and improve infrastructure. The 12th Five Year Plan will begin in 2011, and is expected to include tax incentives and talent stipends that support IT services.
**Node 3: Is there a sustainable competitive advantage?
VanceInfo has been positioning itself as an alternative to India based IT outsourcing of R&D (60% of revenues), enterprise software development, along with quality assurance and testing. Their largest customers (Microsoft, Huawei, Expedia, Citigroup, and TIBCO) accounted for 56% of sales. They compete primarily against Chinasoft, Neusoft, HiSoft Technology, iSoftStone, and the Indian IT giants. Their customers are located primarily in China (42% of sales), the US (36%), Europe (16%), and Japan (5%). IDC ranked VanceInfo as the #1 Chinese offshort software development vendor for North America and Europe by 2008 revenues.
Wage costs for IT professionals in China are roughly 2/3rd the comparable wage costs in more developed countries and India. However, the wage costs in Chinas IT services industry is starting to increase at a faster rate than in the past. Over time, the wage increases will not likely bring China IT outsourcers close to parity with Indian companies, due to a larger labor pool needing work but it will relatively reduce their competitive advantage and profit margins. Vance didnt see any wage inflation in 2009, but this is something to keep an eye on for the Chinese IT outsourcers going forward.
** Node 4: Is there leverage in the model (operating/multiple)?
Operating leverage?:
Revenue growth: 2007-2012E:
116%, 64%, 44%, 37%, 25%, 38%
EBIT margin: 2007-2012E
13%, 14%,14%, 16%, 16%, 16%
Vance Info is growing their topline by aggressively growing their headcount. In Q1 2010, Vance added 916 new employees, including 795 billable professionals, driving its total headcount to 9,263, up 53% YoY. At the end of 2009, management had guided headcount to grow to 10,400 by the end of 2010, with a goal of 20K in 2-3 years.
This addition of headcount has increased operating expenses in relative lockstep with the topline you can see this by the slow EBIT margin expansion over time, even while revenue is growing by ~40% a year for 4 years in a row.
The Chinese government is supplying subsidies and tax breaks to support the software industry as a result, their net margins have been slightly higher than their operating margins over the past few years. Taken together, we can say that operating leverage is driven solely by topline for the forseeable future.
Valuation leverage?
Vance Info Services trades at 29x its forward earnings, compared to 21x its historical average. It trades at similarly 25% elevated levels to its 5 year average on other valuation metrics including P/B, P/S, and EV/EBITDA. The stock is up 60% YoY and 30% YTD.
***** HQ: Beijing, China
***** Management:
Chris Shuning Chen, CEO - founder, chairman and CEO. He co-founded our company in 1995, served as a managing director from 1995 to 1999 and became the CEO in 1999. Before Vance Info, Chen worked as a senior software developer at Great Wall Computer Software & System Co. from 1989 to 1995. Chen received his masters degree in engineering from Huazhong University of Science & Technology and his bachelors degree in mechanical engineering from Tsinghua University.
Sidney Huang, CFO - COO since August 2008 and CFO since July 2006. Previously, he was the CFO of Longtop Financial Technologies Limited, a China-based software development and IT services provider, from 2005 to 2006. From 2004 to 2005, Mr. Huang served as the CFO of 800buy China Limited, an e-commerce company. Prior to 2004, Mr. Huang was an investment banker with Citigroup. He also served as an audit manager of KPMG. Mr. Huang obtained his MBA from the Kellogg. Mr. Huang is a CPA.
Source for bios: Company website.
***** Price performance, Valuation, Growth expectations:
Stock Vanceinfo Technologies Inc
Mkt Cap ($US) $1,036
Price US$ $25.98
1wk % 2
1mo % 7
3mo % 2
12mo % 63
vs 50day 1.12
vs 200day 1.26
Rev Grw FY'10 37%
Rev Grw FY'11 25%
EBIT % '10e 16%
EBIT % '11e 16%
P/E FY '10 34
P/E FY'11 27
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VanceInfo Technologies Extended Look --- Oct 2010
** Conclusion: This was really useful. I frankly can’t imagine getting involved in Vance anytime real soon, but it’s worth another round of work to examine NODE #3 to see if we can grow ANY conviction that Vance will generate a sustainable, unfair competitive advantage … and … perhaps more importantly, learn more about their specific sales proposition to customers in NODE #2.
A thought: Vance is another company that is growing rapidly inside a space that is still extreeeeeeeemely early in James Utterback’s “dynamics of innovation” process. The Chinese outsourcing industry is sooooo early in its lifecycle that how it plays out, what becomes a ‘standard’ practice, and who wins are questions that are extremely difficult to answer right now.
My quick “top takeaways”:
- The near-term business driver is mostly about domestic outsourcing. My sense is that the work coming from outside of China is mainly limited to some anchor clients who have worked w/Vance for awhile. But recent business is local.
- In NODE #2, from a Change Function perspective, there is a healthy mix of crises that will drive opportunities and TPPAs (total perceived pains of adoption) that will inhibit them. All things considered, I’m positive but to the extent that the promise for Vance is supposed to come from *outside* of China, I’d be much less positive. That is, there are enough TPPAs to make me think it’ll take a long time to develop…
- However, I’m intrigued by the opportunity around domestic outsourcing. Much more to learn here.
- I have a big question-mark around NODE #3. And, frankly, *time* might be the only thing that *really* helps me grow conviction here. How will the competitive landscape play out? Seemingly, there’s a lot of dust to settle.
** What would I need to know to make Vance a top 10 long position?
#1: that the demand from local clients was strong enough and long-lasting enough to build a bridge from today to the point when the rest of the world gets serious about outsourcing to China.
#2: Some clarity on the competitive front. The 1000 company rule (more on this below) --- who is it comprised of? How many companies are there … really …. ?
** Context: The goal today is to simply develop a better understanding of NODES 2 and 3. It’s my first look at Vance after Aaron’s Quick Look … so it’s pretty much all about knowledge building w/regard to NODE #2 and #3 as opposed to wisdom generation or model work in NODE #4.
** NODE #2: CUSTOMER CONCENTRATION
The point: Aaron commented on the customer concentration but I want to stress it again because it shows just how early we are here. 56% of revenues from the top five customers (Microsoft, Huawei, Expedia, Citigroup, and TIBCO). Not surprisingly, Vance’s total customer count is relatively low too. They've increased the number of clients from 98 for 2005 to 272 for 2009 … but I suspect a good number of that is through acquisition.
The good news? The number of our clients with at least US$1 million in annual revenue increased significantly from
11 for 2007 to 22 for 2009.
** NODE #2: WHAT – REALLY – HAVE BEEN THE GROWTH DRIVERS?
This was eye opening. The point: business is being driven by (at least thru 2009) demand from local Chinese businesses --- NOT necessarily multi-nationals looking for cost savings in China.
Here is Vance’s revenues by geography: 2007 thru 2009, in millions
- China: $7.4 … $22.0 … $59.4 ….
- US: $43.2 .. $56.2 … $56.6 ….
- Europe: $6.3 … $14.9 … $23.1 ….
- Japan: $5.8 … $9.2 … $8.5 …
So what? Wow. Look at the growth in China… and the lack of growth in 2009 from the US. Note: these figures represent where the client’s headquarters are located. Later, in KPMG’s report, they said that in 2008, while China made up 22% of revenues, if you measured it by the location of the entity signing the contract as opposed to where the headquarters of the customer was, China would be more like 71% of revenues. So, this 71% might include … say … an IBM office that is based in Shenzhen.
Data point for context: In 2007, offshore work in china represented only 15% of the country’s total $2.3bn IT outsourcing market. Another data point: In China 10% of all IT is outsourced. KPMG says the US is more like 30%. The point: IT outsourcing is very early in China, but it’s growing.
Next to do: review 1H 2010 results. Have they shown any new growth from the US in the past six months?
** NODE #3: COMPANY ORIGINS
One thing to learn more and more about as we go: what’s this company all about?
Here’s their origin: Vance started in 1995 by offering globalization and localization services to help clients penetrate local markets. It was then that they also started their engagement with several key clients, like IBM.
Vance’s globalization and localization services consist of a multi−step process to create the specific language versions of client’s software and hardware, including software applications, printed documents, communications materials, website contents, desktop publishing, E−learning and training content.
Today, it seems as though a key service Vance provides is *still* about helping clients with cultural and linguistic issues. I imagine part of their promise is helping local Chinese customers do the same abroad – that is … say … helping Huawei with such issues in … say … Norway.
Key question: What is the value proposition they sell????
This bit is rather interesting …
While much is (appropriately) made about Do More With Less, another value proposition involves getting customers up close and personal with the local Chinese market. In their 20-F, Vance talks about its relationship with Tibco. “Our presence in major Chinese cities and our deep understanding of the Chinese culture and the local market dynamics help us provide prompt technical support to TIBCO’s Chinese sales force. For instance, we assisted TIBCO in successfully securing two Chinese banking customers in 2007. Our dedicated professional team for TIBCO in China does not face the distance, time and cultural differences encountered by TIBCO’s U.S. team with its Asian customers. We believe that our participation in TIBCO’s sales and marketing activities presents new opportunities to further develop our relationship, and will contribute to our revenue growth while creating additional value for TIBCO.”
So what? Wow… so … they injected themselves into the sales process? We’ve had this suspicion all along, but I’ll reiterate here: comparing Vance (and other Chinese outsourcers) to INDIA will likely be an utter waste of time. They’re reaaaaaaaallly different, and I think it’d be good to learn more about exactly what types of services they offer.
I think it’s really really really important to learn more about what services they offer and what value proposition they sell.
Among the options:
- #1: Selling Do More With Less to international companies. My sense is that this would be the most conventional “bull case thesis” for Vance considering wages are even less than India. However, (a) there’s been a slowdown in business from the US (at least thru 2009). And, (b) judging by the TPPA’s I describe below, I’m not interested in pursuing Vance based on *this* thesis.
- #2: Helping multi-nationals penetrate the Chinese market by …say … injecting themselves into the sales process as they did with Tibco. My thought? Interesting and worth learning more about, but it still seems like a tough sell.
- #3: Selling Do More With Less to local Chinese companies. This could be very very interesting. However, I think it’ll take us a good while to build knowledge about trends in local Chinese outsourcing practices.
- #4: Helping local companies sell into foreign markets. Vance claims to be adept in 65 languages … so, I gather part of their promise might be to help local companies penetrate global markets, which could be very interesting. A Digital – and Cultural – Ferryman, of sorts… ? Dunno.
At any rate, I think learning more about who their customers are and what work they do is vital!!!! I think doing an Extended Look 2 on this topic alone is a good use of time.
** THE INNOVATION BLOWBACK
Conclusion: to the extent that Vance sells “globalization”, this trend is a positive.
I described this in Waypoints 95. “Innovation blowback” is a phrase coined by McKinsey in 2005 or so that suggested that, increasingly, Chinese companies see themselves less as cheap-labor outsource companies and more as the creators of intellectual property that can be exported to – or exploit – markets outside of China.
KPMG referred to a similar trend, but they called it the “reverse brain drain” and said that Chinese engineers and businessmen who have been educated abroad come back to share knowledge and work and western management skills in China.
On my trip to China in 2008, this came up repeatedly (after merely being a ‘budding conversation’ during my 2006 visit).
So what? So … is China still an outlier when it comes to outsourcing IT? Yeah, I think so. But do I think it is very serious about, and very capable of, raising its game? Absolutely. This is a NODE #2 to – at the very least – track.
Example: Vance says that for Tibco, as of March 2010, it maintained a high−quality R&D team, all of whom hold undergraduate and graduate degrees, with about 15% of them having completed part or all of their education in the United States, Europe, Australia or Singapore.
** NODE #2 & #3: THE 1000 – 100 – 10 PROJECT
Conclusion: Here, there are positive takeaways relative to NODE #2 but some concerns flare up in NODE #3.
In his Quick Look, Aaron talked about the government’s role in building a NODE #2 for China’s IT outsources as part of a 5yr plan. Well … in 2006, the gov’t announced the “1000-100-10 project”. I think as part of the 5yr plan … but it provides a lot more detail.
The goal:
- Develop a base of 10 internationally competitive cities.
- Encourage 100 well known transnational co’s to transfer outsourcing business to China
- Cultivate 1000 medium and large sized service outsourcing organizations with international qualifications.
As part of this, gov’t has focused on Infrastructure (power supply, broadband, telecom) as well as education and, specifically, English language skills.
The plan consists of:
- Funds & incentives to improve technical skills.
- A framework for better protection of IP
- A centralized website that provides information about China’s outsourcing mkt for academia, research institutes and businesses.
- Improvements in infrastructure
- Loans and credit insurance for outsourcing companies.
- A subsidy of $650 to a vendor for every college grad that is employed for at least a year.
- Interest rates that favor exporters of software services.
- Priority to software businesses when applying for listing on domestic or overseas exchanges.
And more.
So what?
Thought #1: Well, it certainly seems like the government is serious. And, they do address some pretty critical TPPAs here (IP protection, technical skills, English language).
Thought #2: 1000 companies???!!!!!! Really? Seems like an awfully tough market to participate in, if it’s true. KPMG notes that China is indeed much more fragmented than India. In China: 20% of the outsourcing market comes from 10 largest vendors. Contrast this with India where 3 largest vendors = 46% of Indian IT exports. Yikes.
Oh, also, since this 1000-100-10 project was announced, the gov’t has since announced 20 cities they want to have as global outsourcing hubs.
At any rate, when I think about China’s ability to change – particularly when the orders come from the government – many existing TPPAs are not worries of mine. I think they’ll get sorted out: Infrastructure, Technical Skills, English (English as foreign language is apparently now mandatory in primary schools.)
But there are some TPPA’s that are going to be tough to overcome:
- Location exposure. Unlike India, China’s IT outsourcing options are not monolithic. Will there really be 20 cities vying for business? This would seem to creates complexity.
- IP protection: Yeah, the government is trying to solve this, but there’s a reason there are two “P”s in TPPA.. The “perceptions” that IP may get stolen in China is going to take a looooong time to eradicate.
- The sheer # of vendors. Is the goal reeeeaallly to create an industry with 1000 companies? My goodness. That would seem awfully complicated for a vendor looking to choose among them.
Lingering questions? Yeah … lots:
- Are there really 1000 companies? There’s already been consolidation in the market. So … what’s the competitive landscape really like?
- Can Vance use scale and service expertise (higher end) to stand out from the crowd?
- KPMG suggests that the winners will win because of low cost, not brand, when it comes to China’s local outsourcing market. What’s the thinking behind this claim?
- Where did Vance’s management study? In the West?
** CONCLUSION: Interesting one …and lots to still uncover. Let’s do an Ext Look 2.
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Related data point for contextual purposes: Global market share of IT services: China 3%. India 26%. (Source: KPMG)
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Vance InfoTech Extended Look 2 – November 2010
** Conclusion: Tough one. If I broke Vance down into two parts, I’d say TRACK for its multi-national opportunity and EXTENDED LOOK for its local opportunity which I find more compelling. That said, regarding the latter, I think the next thing to do is to find contacts who can help us develop knowledge. Without that, I think more work is a poor use of calories. So … lets leave Vance in Extended with no date and have a brainstorm about who we can question …if anyone.
** Context: The big takeaway from my last look was that the strongest growth driver for Vance has had (at least thru 2009) very little to do with multi-nationals outsourcing work to China and most to do with Chinese companies outsourcing domestically. In this round of work, I want to focus on:
- #1: Review 1H 2010 results. Have they shown any new growth from the US in the past six months? Or is this business still all about Chinese local outsourcing?
- #2: KEY question: What is the value proposition they sell to clients in China? What services do they offer?
Let’s dive in:
** 1H 2010 UPDATE
As a reminder, in my last round of work I noted that China represented 40% of revenues up from 11% in 2007 and up well over 100% y/y in 2009. The US, meanwhile, had been flat at $56mn from 2008 to 2009 and as a % of revenues, it had fallen from 70% of revenues in 2007 to 38%.
What has happened in 1H 2010?
- Total revenues are up 49% y/y.
- China revenues have grown 98% y/y and now represent 45% of revenues
- US revenues have grown 22% y/y and now represent 35% of revenues.
- European revenues have grown 32% y/y and now represent 15% of revenues.
- Japan has fallen 7% and now represents 4% of revenues.
So what? So … China is still the most exciting market but US growth has returned after a flat 2009. Encouraging.
Client contribution, meanwhile, is still very concentrated. The top 5 clients still represent 58% of revenues (down from 60% a year ago) and the top 10 clients still represent 69% of revenues (down from 71.5% a year ago).
** SERVICES: PART #1
What kind of services does Vance offer?
In 2Q 2010, this is the breakdown of Vance’s business by Service Lines:
- R&D Outsourcing: 63% of revenue, down from 68% a year ago.
o R&D Services: 62% of overall revenues.
o Globalization & Localization: <2% of overall revenues.
- IT Services: 34% of revenue, 31% a year ago.
o Enterprise Solutions: 10% of total revenues
o App development & maintenance: 19% of total revenue
o Quality Assurance & testing: 5% of total revenue.
- Other: 2% of revenue. (BPO & System Integration).
** SERVICES: PART #2
What’s involved in the major service offerings? What are some specific use cases?
I’m going to focus on R&D Outsourcing, since it’s 63% of revenues.
It consists of three things:
#1: Globalization & Localization: this is just 1-2% of revenues so I won’t spend much time on it. But it helps companies create multi-lingual content. Or, if a company is setting up a development center in China, Vance can help with the set-up, training and knowledge transfer.
The other two services are software product development and product testing. I’m not sure what % of the business each contributes, but together they add up to 62% of revenues.
#2: Software product development: Vance offers two case studies on its site:
a) A mobile social network start-up located in Silicon Valley. The client wanted to develop an image/audio rendering engine to render huge amount content and implement special effects to the content. To do so, Vance & the client worked in parallel and eventually developed a web-based multi-media content platform that allowed for uploading and management of pictures, music, and video. The platform let users can share with friends, blog, add comments, and participate/vote in contests. They also developed a Facebook plug-in that allowed the client’s customers to send gifts to friends’ mobile phones. Along the way, Vance said it held daily Webex calls with the client, delivered services across the product lifecycle, set up a complete replicate server side development and testing platform in China.
So what? I don’t know who this client was … I don’t know whether this platform was indeed successful … and I don’t know how big of a deal (revenue wise) such a project was. But it strikes me as far more than “labor arbitrage”!!! I’m more positive. Again, I don’t want to make too much of one use case, but such deals smack of GRANULARITY. Vance *could be* superbly positioned relative to granularity.
b) The second use case involves a software integration company who sought diversification away from India as well as close proximity to TIBCO’s end market. Vance built a development center with a team of several hundred engineers. My sense is that *this* use case effectively just involved transplanting an R&D center that was in India into China where they’d continue to do Development, QA & Testing, Technical Publications and Technical Support. Along the way, Vance says it helped the client cross-sell services for some local clients and even got involved in the company’s marketing efforts to win two deals w/local banks.
#3: Product testing & verification: this is fairly self explanatory. The use cases Vance presents includes:
- A financial services company (Citigroup?) that has over 200mn customer accounts wanted to adopt a system to manage its financial services ranging from retail banking and credit cards to capital markets services. The system required rigorous testing before launch.
- The other involves a European mobile phone manufacturer (Nokia) who required software testing of Symbian-based platforms and products prior to market shipping. Vance says it now provides software testing services for a majority of the client's handheld devices and says that >80% of the company’s handsets on the market today have received testing from Vance.
So what? I’m still quite interested. The range of services offered by Vance is wide and the #1 thought I have after this work is that Vance seems to be more of a “serious business” than I had thought. Let’s compare it – in size – to other vendors for some context…
** CONTEXT: VANCE’S SIZE
Here are a couple metrics for Vance relative to some other offshore companies, including some in China.
The point: Vance is TINY compared to other “global” participants. However, in China it is one of the majors…
Revenue (CY10E) and Employee count.
- Vance: $200mn, 10,000
- HiSoft (China): $145mn, 10,000 (listed on Nasdaq if we want to look)
- Neusoft (China): $720mn, 17,000 (listed in China)
- Camelot (China): $180mn, 2,900 (listed on Dow Jones)
- Sinocom (China): $80mn, 3,000 (listed in Hong Kong)
- ChinaSoft (China): $165mn, 8,000 (listed in Hong Kong).
- Some key privates in China: Bleum, iSoftStone, BeyondSoft
- Cognizant: $4.5bn. 89,000
- Infosys: $6.1bn.
- Wipro: $7.0bn
- TCS: $8.3bn
- IBM Global Svc: ~$40bn.
** CONCLUSION
Hmm. Tough one. I’m still interested in pursuing Vance as a long candidate. However, I think the thing to spend time on is to develop a deeper understanding of the LOCAL NODE #2 opportunity. My sense is that while the ‘global outsourcing’ thesis (from multinationals) is interesting in its own right and well worth tracking, Vance is small fries on the global scale … it has customer concentration that I’m not comfortable with … and my conviction that the crisis / total perceived pain of adoption dynamic for multi-nationals to outsource to China is murky. In other words, if I were assessing JUST the multi-national opportunity, I’d want to TRACK Vance.
However, my sense is that the LOCAL NODE #2 opportunity is far more compelling. I don’t doubt the competitive landscape is crowded, but my sense is that Vance is establishing itself as a leader. And … would most local Chinese companies would rather work with local Chinese outsourcers than … say … TCS or IBM or Accenture? Seems reasonable. But there is a LOT to learn about this market. I’d love to find a contact who can help. I do NOT want to read 3rd party research from IDC or Gartner or the like. My sense is that while that type of research always has significant shortcomings, in *this* case, relying on it would be downright dangerous. It’s a market that seems reeeeaaaallly easy to hyperbolize. So – if we can find a trustable, knowledgeable contact in the China market, let’s go full-steam ahead on this one. If not, I think we move it to monitor and look for spots to learn more through friends.
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VanceInfo Tech Extended Look 3 – December 2010
Call with IR: 011 86 13901041882 – Melissa Ning.
** Conclusion: Move to MODEL, Long. Not urgent. Note: the lack of urgency shouldn’t be interpreted as a lack of interest. Rather, it’s a function of (a) other compelling candidates in our long funnel (e.g. Agilent, F5) and (b) the notion that Vance is extremely early in its lifecycle and if we decide to get involved, we’ll have a long runway of opportunity.
** Context: While there is plenty to learn about the customer base who is using Vance’s services, we’re pretty much sold on the NODE #2 opportunity. Last week, I had a chance to talk to Vance’s IR group, and my focus was more about NODE #3.
** NODE #3 CONSIDERATIONS
Q: What is your core competency? The context here: we’ve applied Utterback’s thinking to VanceInfo in our previous looks, and one bit of advice Utterback gives includes to focus your competitive efforts in appropriate fashion recognizing what stage of innovation the market is in. That is, if a market is in Stage #3 Process Innovation don’t try to be a product innovator. Utterback’s work – when married with cultural examination – also suggests being aware of what your core competency is in the first place. If your competency is process innovation don’t kid yourself that you suddenly you can easily generate a new core competency overnight to be a product innovator.
Answer: a combination of three things:
• Reference accts
• Responsive mgmt.
• Quality work.
The company provided some context about the competitive landscape. They reminded me that 73% of their business is from China – either a multi-nat’l operating in China or a domestic company. With that said, they are mostly competing with Chinese vendors. (Indian co’s are tinkering here and there but given the nationalistic spirit in China, I can’t imagine them representing much of a threat at all!).
And … among the Chinese competitors, different companies have different expertise – whether that involves coverage in geography … or verticals.
One byproduct of this: VanceInfo doesn’t run into the same companies in all RFPs. It’s *highly* fragmented.
Neusoft has a good presence with handset makers
HiSoft is has won some business with Huawei (as has Vance)
Vance is the exclusive vendor in China for Expedia (beat HiSoft for it)
So … when you do compete with locals, what is the advantage?
Answer: Reference accts, Responsive mgmt., Quality work.
Regarding the immediate response…
Expedia sent their RFP on New Year’s Day in China (last year?) and wanted immediate response. Vance turned it around in one day.
What accounts for the rapid turnaround?
Answer: There is a high level of attention given by senior management. Vance’s CEO flew to the headquarters of Expedia to give support to project.
My thought: perhaps there is something cultural that makes Vance different and that makes its NODE #3 advantage “unfair”, but my thought is that among the three things the company says give it its advantage, the Reference accounts might be the most “unfair” right now. In such early stages of a market’s growth, I suspect they go a LONG way.
Q: What can you tell me about your management team? What makes them right for the job?
Answer: there is a nice balance of East / West on the team. That is, ½ are local and ½ have come back from overseas. So, there is great knowledge of the local markets as well as operational procedures and expertise brought back from ‘the West’ which are valuable.
My add: I have a (low conviction, mind you) thought that the “Western experience” isn’t as much of a differentiator as the Chinese companies would have us believe. Yes, I DO think that having management that has experience in the West lowers the TPPA for signing new clients from the West since it helps build a bridge linguistically and culturally. It mayyyyy also help with industry connections and ‘leads’. But … beyond that, it’s talked about SO much (whether by IT outsourcing co’s or gaming co’s in China) that I have this sneaking suspicion that it’s not nearly as big of a differentiator as the Chinese co’s would have us think.
I asked if this was *really* unique, and IR said that most other top competitors also have mgmt. teams with Western ties, but “not to the extent” Vance does.
At any rate … the company also talked about its addiction to making money. “We know how to manage costs well”. They claim to have the highest margins among peers (something I have yet to verify but that can be done during our model work).
IR claims that its CEO takes economy class flights even when flying to North America … acknowledging that, indeed, HiSoft is now copying them in this regard after having let their CEO fly business previously.
** NODE #3 CONCLUSION: My thoughts:
#1: First off, my conviction about NODE #3 is low and will likely remain low given how early the market is in its lifecycle and how early I am personally to the space. I’d love to meet some local contacts who could help us learn more about the various participants first hand. Something to work on…
#2: My sense is that Vance doesn’t have anything that is necessarily “unfair”, but that’s not to say I’m no longer interested. That is, I don’t see a “secret sauce” that allows them to do something no one else can. But I think they’ve built a really solid NODE #3 position through early key wins (whether thru quality work or responsiveness) and that they now have the scale, the reference accounts, and the reputation to put themselves in a very good competitive position in a market that is growing fast enough to support growth for many participants.
** NODE #2 CONSIDERATIONS
Context: As I said earlier, we’re “pretty good” with the NODE #2 opportunity in front of Vance, but I wanted to get their thoughts on some lingering questions…
Q: What are the top value propositions you sell to clients? What is the crisis they are coming to you to solve?
Answer:
#1: For multi-nationals, strategic interests. They “have to have” operations in China. So it makes sense to have local IT support.
#2: Diversifying away from India. Customers don’t have to end vendor relationships with Indian co’s, but they are seeking to diversify w/other alternatives, and China is on top of the alternative destination list (abundant labor poor – 6mn graduates coming to labor market).
#3: domestic economy / demand.
Here, the company introduced the idea of how the gov’t is focused on the IT outsourcing market. They claim that of the 6mn graduates that are coming to the labor market each year in China, 2mn are in science and engineering, 28% can’t find a job, and 12% can’t find a job after 6mo’s.
Q: How does this impact wage rates and inflation?
They have no exact #s on attrition – but they claim it’s lower than India. Wage increase at Infosys is at 15-20%; Vance is at low single digits. Attrition? It can range from low single digits to 15-20% depending on the type of work at Vance.
Q: What companies have you added to your list lately? Work coming from outside of china seems like anchor clients? Any new high profile adds?
They disclose the major client names. Expedia, Huawei, Microsoft, Tibco, Nokia, Citibank. China Telco, China Mobile.
Expedia was added last year. Cathay Pacific this year.
Note: Normally, they have to wait a few years to ramp the revenues and type of work. So, in the beginning of a relationship, it might not be a ‘major customer’ eve if it is a ‘major company’. Makes sense.
** CONCLUSION
Nothing dramatically new here. I still think the bulk of our remaining questions are in NODE #3, and I’d love to get connected via our Fellows to some folks who know the domain well. In the mean-time, I do think it’d be good to move forward in the funnel and complete a model….
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VanceInfo Tech Model – January 2011
** Conclusion: Follow-up, long. No date. This model work doesn’t tilt me dramatically one way or the other. I still have the thought that it’s going to take a lot of time to build conviction about the business conditions / drivers in China. I absolutely remain positively biased, but I don’t see us coming to completion soon. What I’d love most is to hear from friends or friends-of-friends who have real-life experience in the China IT outsourcing market.
At any rate, sticking to today’s exercise, the model work makes me think more digging is appropriate. I just want to be cognizant of where this one falls in our priorities.
** Headline estimates: 2008 to 2012E
- Revenue Growth: 64%, 44%, 42%, 28%, 29%
- EBIT Margin GAAP: 14%, 15%, 16%, 16%, 16%
- EBIT Margin Non-GAAP: 17%, 18%, 17%, 18%, 18%
- EPS: $0.45, $0.60, $0.80, $0.97, $1.23
- Valuation: 36x 2011 EPS
** Direction of estimates
Good. In the past 12mo’s, Vance’s 2010 EPS estimate has risen from $0.70 to $0.80 as sales estimates have increased from $184mn to $209mn.
** EBIT margin considerations
Here are the line items that contribute to Vance’s EBIT margins (from 2008 thru 2010E).
- Gross Margin: 39%, 38%, 38%
- Other (Gov’t Subsidies – include as “other operating income”: 1%, 1%, 2%
- SG&A: 25%, 23%, 24%
- Non-GAAP Add-backs (options / amort): 2%, 2%, 3%
- EBIT Margin: 17%, 17%, 18%
So what? One follow-up question is whether the company has a stated long-term EBIT margin target. It’s been remarkably steady over the past few years. Is this an indication of what they target in the future?
** Segment Mix
Vance breaks down its business into six segments. Here they are … with y/y growth from 2008 to 2010E.
- R&D Services: 62% of revs. 69%, 49%, 44%
- Globalization / Localization. 3% of revs. 12%, 20%, 19%
- Enterprise IT solutions. 10% of revs. 56%, 7%, 38%
- App Dev & Maint. 18% of revs. 83%, 55%, 53%
- Quality Assurance & Test. 6% of revs. 43%, 16%, 62%
- Other. 2% of revs. NM, NM, 35%
So what? I’d be interested in knowing whether any of these have higher margins than the others, but the key takeaway here is that R&D services are the key engine in this model. AND … it’s been growing consistently (unlike App Dev & Maint and Enterprise IT which seemed to have been adversely impacted by the cycle in 2009).
(Note: see my Extended Look from November for more on what types of services are included in R&D Services).
** Cash Flow / Balance Sheet
Nothing dramatic here. The company carries no debt. It has a cash balance of about $80mn (against a market cap of $1.58bn). And it generates cash.
** Misc.
- Tax rate: Vance’s nominal tax rate in 2009 and 2010 is 7.5% because of various subsidies and tax breaks from the Chinese gov’t. Models I’ve seen on the Street peg the growth rate at 12% in 2011. I’m not sure what an appropriate long-term rate would be … but for my DCF, I’m using 12%. It’d be wise to ask the company about this, but I’m not expecting the tax breaks to run out anytime soon considering the push the Chinese gov’t is putting behind IT services.
** Decision Engine
Using the following assumptions, I get a DCF value that is exactly equal to the company EV (as of 1/19): $1.5bn. This puts Vance in the 3rd quintile.
- Mid-term growth: 16%
- EBIT margin: 18%
- Tax rate: 12%
- Terminal: 4%, WACC: 10%
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March 2011
** VANCEINFO RESULTS
Conclusion: Little drama. Thesis intact. I’m modestly biased toward adding a bit to our 0.5% position.
VanceInfo Tech, an IT solutions and software development company in China, will benefit as (a) the crisis to Do More With Less drives more and more outsourcing generally and as (b) the institutional imperative for CIOs to “have a China plan” intensifies over the next few years as the country establishes itself as the economic engine of the planet. Competitively, VanceInfo is well run and will leverage its early well-established position to take advantage of this extremely attractive NODE #2 market opportunity.
Headline results:
Revenue of $59.6mn grew 38% y/y and beat consensus of $57.5mn. EPS of $0.22 beat by a penny. Guidance was inline.
Among the key considerations in our pre-determined game plan:
** Burning Question: 2011 REVENUE: Can it grow 28% y/y after 2010’s 43%?
Update: There’s no new information that makes me any more positive or negative about 2011 guidance. I still think it’s doable.
Guidance was for 2011 implies 28% y/y growth (in line w/previous estimates).
My conviction in Vance’s ability to meet it? Relatively high. 7 out of 10.
A) While using historical q/q trends don’t tell us *that* much (given a small historical sample set), if we use 2010’s q/q growth pattern in 2011, VanceInfo would grow 38% y/y. And, if we use the q/q pattern from 2009, we get 37% y/y.
B) Vance ended the qtr with 11,044 employees, up 32% y/y and 4% q/q. Billable headcount increased 30% y/y and 3% q/q to 9,827. The point: while headcount growth doesn’t necessarily mean revenue growth will follow suit, it does suggest that (a) mgmt sees demand as being strong enough to necessitate such headcount growth and (b) Vance has the capacity in place to meet the 28% bogey.
C) VanceInfo is still small. Its revenue guidance for 2011 is $270mn. By comparison, Cognizant’s will be on the order of $5.8bn. Infosys: above $7bn. Wipro about $8bn. To be clear, these are very VERY different companies with a muuuuuuuch broader set of customers and comparing them has serious limitations. But, my point isn’t to *compare* them. My point is to shed light on how large the market opportunity is … how small Vance is … and how much growth runway may still lie ahead.
At any rate, I think the 28% growth bogey seems doable.
** “Where wrong” risk: CUSTOMER CONCENTRATION: Does this undermine the idea of a massive, wide NODE #2 market?
Update: this is still a key to watch – particularly given the comments I just made about the large NODE #2 opportunity. The top 5 customers in the qtr made up 54% of total revenue compared to 53% last qtr and 57% last year.
So – progress – but I’d like to see more “de-concentration”.
Encouraging: geographically, all regions grew nicely. China grew 49% y/y (47% of revs). The US grew 26% y/y (32% of revs). Europe grew 32% y/y.
Lingering question: I’d like to see the company’s filing to see how much “total customers” grew and how well it is seeding its overall customer base, even if not “large deals”.
** Burning question: EBIT MARGIN: What is the company’s long-term target?
Update: No mention of what the long-term target is, but for 2011 the company expects EBIT margins to remain stable from 2010’s level which was down 40bps from 2009. (GAAP margins for the full year 2010: 15.1%. Non-GAAP: 17.5%.) The company attributes the lower EBIT margin to enhanced sales efforts, the buildup of centers of excellence, add’l investments in office expansion, staff training, and the recruitment of more mgmt. talents. All told, in 4Q, SG&A grew 52% y/y and for 2010 as a whole it grew 49% y/y.
My take: my sense is that this company is highly “dedicated to making money”, but let’s keep watching their investment plans and EBIT margin trends. Interesting tidbit: I haven’t read a transcript of the call yet, but one broker note I read made mention of the company’s longer-term strategy to invest profits over their target EBIT model “for growth” – similar to Cognizant’s strategy and something that suggests the company has an adequate amount of control over its EBIT margin.
Conclusion: Nothing too dramatic here. I think our thesis is intact as are some lingering risks / questions. If anything, I’m modestly biased to take our 0.5% position higher. Not that I’m significantly more positive … rather, I just think it makes sense to move Vance from its “starter” position toward an average sized position.
