Of Nano and Fighter Jets

The engineering services division of Tata Consultancy Services (TCS), Indias
largest IT services firm, was making a sales pitch to one of its clients, an
Italian aerospace company, which was looking at a new variant aircraft program
for US and other global markets. TCS was trying to get the design work for a new
manufacturing tool. The client, who was also looking for a cost-effective
manufacturer, got an unusual proposal from TCS. The IT services firm said it
could not just design the tool but could get it manufactured in India at a
competitive cost and deliver the end product to the client. The client, though a
little skeptical in the beginning, finally agreed, considering the background of
TCS parent, the Tata Group. TCS quickly got into the act and roped in group
company TAL Manufacturing Solutions, the groups contract manufacturing arm. The
designing is over and TAL is manufacturing it in India.

TCS is calling it concept-to-manufacturing. India, which fast transformed
itself from an agriculture-led economy to a services-led one, skipped the
manufacturing wave almost completely. Many have argued that India could actually
get into manufacturing through the services route. Critics, however, have
dismissed the idea, calling it wishful thinking, far removed from reality. IT
services, Indias main strength, they argue, has little synergy with
manufacturing.

IT services, yes. Engineering services, no. Engineering design, which now has
a sizeable base in India, is actually closely integrated with manufacturing.

And if TCS experimentation it is still early to call it a trend succeeds,
the Indian dream of services to manufacturing may just become a reality.

The Next Big Thing

That does not mean that the ultimate measure of the success of engineering
design off-shoring to India is whether or not it is able to turn India into a
global manufacturing base. In its own right, engineering design services offer
huge opportunity for India to tap. According to a study by Booz Allen & Hamilton
for Nasscom, published in August 2006, the global spend on engineering services
was close to $750 bn in 2004 and is growing. The study estimated that by 2020,
India could earn close to $30 bn from offshored engineering services.

In hindsight (it was published exactly two years back), it seems even Booz
Allen Hamilton had underestimated the potential. Of course, that was at a time
when Nano was not launched and the Tatas had not acquired Jaguar/Land Rover.
Both of these events have given significant boost to Indias image as an
engineering powerhouse.

With a revenue figure of $2.5 bn (and we have not included software product
engineering, semiconductor design, and other high tech/telecom engineering) in
FY 08, the industry could surpass that $30 bn mark (which includes areas that
we have excluded) by at least three to four years before 2020.

In FY 08, engineering services (excluding the areas mentioned above)
accounted for revenues of Rs 10,110 crore ($2.5 bn), growing from a base of Rs
8,050 crore, or $1.8 bn. This was a growth of 25.6% in rupee terms and slightly
more than 40% in dollar terms.

Already, engineering services account for the second largest area (after BPO)
outside enterprise IT for most large IT services firms, which have ventured into
this, including TCS, Satyam, and HCL. In terms of average revenue realization
per employee, as of today, engineering services is comparable to IT services.
However, considering the fact that an employee takes at least three years to be
fully productive in engineering services (unlike IT, where it happens in six
months and in BPO, where it can happen even in two month), and most companies
have just begun their journey, both revenue realization per employee and margins
will only better with time.

Engineering services share in the entire IT services pie has increased from
about 4% in FY 07 to more than 7% in FY 08. Yet, many stakeholders believe
unlike IT and BPO, the tipping point for engineering services is yet to be
reached.

Broader Trends

Like in IT services and BPO, cost and access to engineering talent remain
the top two drivers of off shored engineering services. So, many of the trends
that have defined the evolution of the industry have been similar, with some
exceptions.

Some of the broader trends over the years include the following:

Hybrid as the preferred approach: Unlike IT and large parts of horizontal BPO,
which in organizations have been centralized for years and in many cases even
outsourced to external agencies, engineering services has rarely been outsourced
in large scale. So, unlike IT outsourcing and BPO, few have debated the captive
versus outsourced model. In fact, some of the most prolific outsourcers like
Applied Material, GM, Cummins, and EADS have taken the hybrid approach of
outsourcing work to vendors in India while opening their own India design
centers.

Emerging market opportunity as a driver: In the last few years, global growth
for most consumer products including automobiles, appliances, and electronic
equipment is being driven by emerging markets like BRIC and other Asian
countries. The economic growth accompanying that has also driven demand for
services such as telecom, real estate and aviation. All these markets expect
products and services at a price significantly lower than those in the developed
world. So far, most firms had tried to achieve those price points by
manufacturing in low cost areas. But in many cases, these markets dont just
need low-cost products, they need products that have a lower cost of ownership,
and some of them like India, China and Brazil have significantly different
needs, which demand radical changes in design. Manufacturers are realizing fast
that those new design projects would be too expensive to carry out in the
existing bases, countries like US, France and Germany. That has led to a
proactive approach in looking for low-cost locations.

Outsourcing more complex work: Like in IT, but much faster than IT,
engineering services firms in India have been able to demonstrate that they can
increasingly do more complex work. But more than that, Indian players,
especially tier-1 IT services providers like TCS, HCL, and Satyam have proved
that they can scale very fast and smooth. This has resulted in companies
entrusting more and more complex projects to Indian companies. Last year alone,
two large deals, one awarded by Arvin Meritor to TCS and one by aerospace major
EADS in a mega multi-sourcing deals to four Indian vendorsHCL, QuEST, CADES,
and Satyamhave shown the level of confidence among the clients on Indian
vendors.

Non-Indian services firms realizing India potential: It may have taken the
non-Indian IT firms decades to finalize their offshoring plans, but many smaller
companies in engineering services have already started flirting with India.
While companies in the construction area, had started a little earlier, last two
years have seen a lot of such firms in automotive and aerospace queuing up in
India. Major names include EDAG (delivery in Gurgaon and Pune), Magna Steyr (Pune),
COMAU (Pune), KUKA (Pune), Hosshin (Pune), and Black & Veath (Mumbai). While
most of these are in automotive or construction, this year is likely to see
activities in aerospace.

The New Drivers

In the last one year, a few significant external factors have driven the
engineering design agenda of global companies in sectors such as automotive,
aerospace, oil and gas, and utility areas. Some of them have far-reaching
impacts on how engineering is done in the future. Some have more immediate
impacts.

Indias defense purchase: In aerospace, which is one of the two top areas for
Indian engineering services providers (the other being automotive), one single
event is completely redefining how engineering is done. India has invited bids
for buying 126 fighter aircrafts, in a deal that is estimated to be somewhere
between $10 bn to $12 bn. Indias offset policy stipulates that foreign firms
that sell products worth more than $600 mn will need to re-invest upto 30% of
the total amount in India to create local ecosystem. For this deal, that amount
has been raised to 50%. That means these firms will collectively spend somewhere
between $4 bn to $5 bn in India. That is significant investment. While what
should be included in that is still not clear at the time of writing (a new
defense procurement policy is expected this year, that will replace the existing
2003 policy), engineering services is being seen as the best bet by the deal
hopefuls to judiciously spend that money in India.

Not surprisingly, there are frantic deal making, partnerships, JVs,
consortia, etc. Six hopefulsBoeing and Lockheed Martin from the US, four-nation
European consortium EADS, Russian MiG, Swedish Saab, and French company Dassaultare
trying to do all that is possible to bag a large slice.

It is a no-brainer that this will redefine the way aerospace engineering is
done in India, and even the world.

Oil Prices: In the last year, oil prices have gone up to more than $140 a
barrel before easing a little in the last few weeks. With no end to this problem
in sight, both producers and users of oil have been doing a strategic rethinking
of their projects. Most automotive companies, for example, now have put more
thrust on fuel efficiency than anything else. Many have undertaken new research
and have even made modifications to major existing projects to be able to tackle
the challenge of high oil prices. Indian engineering services firms have already
started getting feelers from their existing clients about these projects. This
will significantly drive how automotive and aerospace engineering is done in the
future.

Indias profile as an engineering base/market: Tata Motors Nano has made the
world sit back and take notice of Indias engineering capability. At the same
time, companies like Tata Motors and Mahindra & Mahindra are emerging in the
global scene as major players in the automotive arena. In addition, due to rise
of local demand, many global automotive companies such as GM, Ford, Chrysler,
Honda, and Volkswagen and Renault/Nissan are not just setting manufacturing base
in India, they are trying to design new India-specific models, which they can
take to other emerging markets. This has brought many tier-1 components
suppliers as well as design services firms to India and this has resulted in
outsourcing as well as partnerships and joint ventures in this area in India.

In addition, a concern on environment is beginning to affect the engineering
agenda of carmakers. Though a little early, many engineering services firms see
the India-US nuclear deal as a major booster for the nuclear energy engineering
work being done out of India.

The Dynamics

The industry can be broadly classified into two categories: the Indian
players and the non-Indian players. The Indian players, which are closely
studied in Dataquest research, account for close to 56% of the revenue accrued
to India from this area, with estimated total revenue of Rs 5,688 crore. Of
that, close to 93% of the market is held by the top 15 players.

The Indian players broadly come from three backgrounds: the large IT services
firms that have pursued this area as a horizontal service line within their
portfolio, the specialized IT services firms with focus on engineering services;
and the spin-offs of Indian companies in engineering segments which have added
to their capability by a mix of organic and inorganic means.

The top three firms in the list, TCS, HCL, and Satyam, belong to the first
categorybroad-based IT services firms. So are some others in the list such as
Patni, Infosys, and Wipro. The specialized firms include Infotech Enterprise,
Geometric, Rolta, QuEST, and Neilsoft. The number of such firms in the industry
is high, though most of them are very small entrepreneurial firms and do not
show up in the radar yet.

The third category is led by Tata Technologies, which started as a small
subsidiary of Tata Motors but grew really big with acquisition of INCAT in FY
06. L&T Infotech still a division of Indian engineering and construction
company, Larsen & Toubro and Mahindra Engineering Services. The others who do
not show up in the top 15 list include a Punj Lloyds group company, Simon Carves
India and Hero Design Services, part of Hero Group. TVS, which had an
engineering arm called Harita, sold the firm to KPIT Cummins.

The non-Indian companies, who contribute the other 40% revenue are largely
consisted of the captives (see list), which account for the lions share. The
non-Indian third party firms, which account for less than 3% of the total
industry is led by the construction companies. Only Magna Steyr and EDAG have
more than 100 employees each in the non-construction area.

With the industry growing and maturing, it is time to examine where it stands
in terms of some basic parameters, many of them direct imports from the IT
services industry.

Onsite-Offshore Ratio: The onsite-offshore ratio is fairly comparable to the
IT services industry, starting with 65-35 (offshore-onsite), going up to 80-20
in some cases. Not surprisingly, large companies do better at this, with Satyam
leading in some cases with even 85-15 ratio.

Acquisitions: Like their IT services counterparts, engineering services
players have also done small but focused acquisitions to add to their skill,
rather than scale (again something like the IT services firms). While many
companies have done acquisitions in semiconductor space including Wipro (Newlogic),
Patni (ZaiQ), and L&T Infotech (GDA); in the areas that we have included major
acquisitions have been those of INCAT by Tata Technologies; Quantech by Wipro;
Plexion and Engines by Mahindra Engineering; global engineering services
division of Modern Engineering by Geometric Software, and Harita by KPIT
Cummins. All these, with exception of Plexion and Harita are overseas
acquisitions.

Partnerships: Acquiring skills in engineering services takes comparatively
longer time than in IT. So, many companies have formed partnerships with
specialized firms to address market needs immediately. Many specialized designed
firms now find that their customers are demanding offshore delivery. Some of
them have tied up with Indian firms to provide those services. Examples include
Alten, a France-based tier-1 supplier to EADS, which has forged a partnership
with Infotech Enterprise; Think 3, an Italian design firm, which has tied up
with Mahindra Engineering Services, and Butler, which has tied up with
Bangalore-based CADES. Even Italian firm Pininfarina, will have financial
participation from Tata Group. Frog Design, owned by Aricent, could also
leverage Indias capability.

Newer delivery locations: Unlike IT, engineering services have always
remained concentrated around the manufacturing base, be it Detroit or the
automotive cluster in Germany or around Airbus in France. So moving to India
itself was a giant leap. In fact, what has helped of late is Indias emergence
as a manufacturing base in automotive, if not in any other industry. The
movement to newer low-cost locations may be challenging, but the industry is
already in the lookout for such opportunities. TCS already has close to 60
engineers in its China facility working in this area and about 30 of them in
Yokohama in Japan. It is setting up a center in Cincinati, Ohio. QuEST has about
55 engineers in Italy. Tata Technologies/INCAT is looking at a center in Mexico.
The other options being considered are Eastern Europe and Vietnam. Eastern
Europe has language and skill, but lacks scalability. Vietnam is low cost but
does not have complex skills. In fact, one of the best engineering locations,
Russia, is not attracting companies, as many of them are unanimous that the
political situation is not conducive for doing business.

Indian firms are trying to move up the value chain by offering more complex
engineering services. Companies like TCS, Tata Technologies and Mahindra
Engineering Services are even trying to use the group expertise to help clients
in more area such as components sourcing and design-to-manufacturing.

As Indian automotive, defence and civil aviation markets see more momentum,
that will significantly affect the offshored engineering services industry in
India positively because more and more specialized companies will come to India,
building depth and negatively because the scarce engineering talent, already in
demand because of IT services, will be a bottleneck. If anything has the
potential to dilute the story, if not stall it, then it is supply of manpower.
That will be a significant issue once the industry moves out of the market-India
phase to scaling up phase. You have heard that somewhere!

Shyamanuja Das

shyamanujad@cybermedia@co.in