The ‘sticky’ outsourcing firms on the rise

This report is from this week’s CNBC’s “Inside India” newsletter which brings you timely, insightful news and market commentary on the emerging powerhouse and the big businesses behind its meteoric rise. Like what you see? You can subscribe here.

India has long been the destination for companies in developed markets to outsource labor intensive tasks.

However, several new technology firms in the country aim to gain a share of research and development budgets – money previously protected for spending in Western markets.

Over the years, the services sector of the Indian economy has grown to account for 45% of total exports, up from 30% a decade ago. Business process outsourcing, or BPO, which includes customer support, drafting contracts or producing mass marketing campaigns, makes up more than three quarters of services exported by value, according to consultancy Capital Economics.

Relatively low labor costs and high IT literacy has contributed to services exports growing by nearly 20% annually over the past two years, significantly faster than the 5% year-on-year increase in goods.

The Indian government, meanwhile, has been eager to support the manufacturing sector in creating mass employment, a key economic and political challenge that the services sector alone hasn’t been able to address.

However, India has also long suffered from the lack of sufficient high-tech companies and jobs leading to one of the largest “brain drains.” For companies, one way to solve this has been to nab a piece of their Western clients’ previously inaccessible research and development budgets.

For instance, the engineering firm Cyient does research and development for 300 firms, including Microsoft and Siemens, across several industries, primarily in the aerospace and communications sector. It has also begun expanding into the semiconductor industry – perhaps the most high-tech economic sector – to help businesses improve their design capability.

Cyient isn’t alone. Peers such as Coforge, Larsen & Toubro’s LTIMindtree subsidiary and others are also replicating the idea, which is now a $30 billion market and expected to double over the next five years, according to Kunal Desai, an emerging markets fund manager at GIB Asset Management.

These companies also boast moats that make them unique compared to the large BPO firms of the last three decades. Once research and development costs are outsourced, they are unlikely to be frequently redirected to another company or country. In effect, these companies become an integral part of the outsourcer.

“Once you’re embedded with a company like Cyient, it’s very difficult for you to strip yourself out,” Desai, whose fund holds a stake in the stock, told an audience of professional investors at Quality-Growth Investor conference in London this week. “These are sticky relationships that the company is able to cultivate, which helps reinforce the competitive advantage of the company.”

However, there are risks here, too. Desai said one key growth element depends on businesses in developed economies accepting that a portion of their research and development can be outsourced.

“Not necessarily the R&D, which is at the leading edge of what the businesses are doing, but the legacy R&D which they can benefit from the cost advantage of scaling it offshore,” Desai told CNBC on the sides of the conference.

If the sector overcomes its challenges, it will make a welcome appearance at a time of rising competition from businesses in countries such as the Philippines, Mexico, Brazil, Poland and Malaysia. Perhaps it could also address some of the risks to employment created in the BPO sector from artificial intelligence.

Behind India’s booming stock market. The Nifty 50 index is up 17% year-to-date and has hit multiple closing highs. There are several reasons behind its rally: public infrastructure investments, the domestic manufacturing sector capitalizing on companies diversifying from China, healthy economic growth and lower U.S. Federal Reserve interest rates. To capitalize on India’s stock market, analysts and fund managers favor the banking and real estate sector.

Indian stock markets have fallen for five consecutive days now to reach a two-week low. Oil price rises due to geopolitical risks in the Middle East contributed to the 2.12% decline in the Nifty 50 today. The index is up 16.2% this year.