When the consulting firm Katzenbach Partners released a report recently describing a metric — called the Relative Value of Growth (RVG) — that purports to measure the strengths and capabilities of outsourcing firms, it caused a stir. Readers interpreted the study to have concluded that Indian IT and business process outsourcing (BPO) companies would soon overtake their Western counterparts. Wharton operations professor Ravi Aron spoke with the report’s authors — Nathaniel J. Mass, managing director of N.J. Mass Associates and Katzenbach senior fellow; Richard J. Schroth, CEO of Executive Insights and Katzenbach senior fellow; and Katzenbach engagement manager Roopa Unnikrishnan — about the gap between the perception and the intention of their study.

Aron: I read your report about the Relative Value of Growth and the metric that you have used. I’d like to talk about the applications of this to your findings about the competitive positions of the Indian IT and outsourcing companies and overseas ones. I understand that you’ve released a report that says that over a period of time, you expect the Indian companies to overtake their Western counterparts.

Schroth: I think that is a misstatement by some of the more aggressive media reports. The Relative Value of Growth basically doesn’t predict a winning and losing situation or an overtaking of an underperforming business. It is basically a metric that reflects the way the market perceives these companies as either growth- or margin-driven.

Mass: The way I think of it is that it’s really a matter of potential. The Indian companies, Wipro for example, have a strong potential to grow profitability. And given their current margins, which are in the 20% to 30% range, they should be able to reinvest in growing in a smart way. They still have to execute, and they have some real challenges like going upscale in terms of consulting capabilities — which they may or may not exploit well, but hopefully they will have the opportunity.

On the other side, with the exception of ACS [Affiliated Computer Services, a Dallas, Texas-based company that provides business process and information technology outsourcing] — which we conclude is a good performer — the other companies are truly challenged. They have a relative value of growth right around one or below, which means they fundamentally have to realign and improve their cost structures before they can grow profitably. That’s their number one challenge, and again they may or may not do that. So to come back to your original statement, I think we would say that there is a significant potential for the Indian companies to grow in a smart way and potentially to be the winners in the space. But there’s a lot of volition on all sides.

Aron: So let’s start with at least two pivots that I see in what you said about the margin. The Relative Value of Growth itself speaks about the drivers of RVG, and you’ve said that growth itself is not very valuable unless it brings margin. And you speak about the cost of capital, and the capital intensity of business and you’ve compared Procter & Gamble to Exxon Mobil. Now let’s start with one observation. Around November 2004, since you mention Accenture and Infosys [two international consulting firms], Accenture had revenues about 14 times those of Infosys, but its market cap was only about a third higher than Infosys. So has the market already discounted the fact that Infosys is looking at growth margins of 28% to 36% while Accenture is looking at about 8.5% to 11%. Have those factors already been built into the market capitalization of both companies?

Mass: Yes, in many ways that is true. What relative value of growth fundamentally does is to take a company’s current market cap as a starting point, then reverse engineers what I call the embedded growth rate — the growth rate built into the stock price — and using that as a point of departure, measures the additional shareholder value created by a point of growth versus a point of margin. Now that’s a very big number for several of the Indian companies. We conclude, for Infosys, that it’s on the order of 50. And for Wipro it’s on the order of 25. To your point, this says that the market sees high growth rates.

Now our calculation would be that the embedded growth rate is not nearly as high as the recent growth rates because you can think of that as a long-term growth rate, or a perpetuity growth rate. But nonetheless the market expects that there is significant growth potential with strong margins. And that’s really a composite assessment looking at their marketing capability, their technology, their customer relationships; a whole variety of attributes. This says that the Indian companies have very strong valuations and they have very strong incentives to grow, meaning they have strong incentives to do smart things to reinvest in their business as well as being a low-cost supplier for the customer segments that value that.

Aron: So let’s take those things that we talked about as drivers of relative value of growth: let’s start with the idea of capital intensity. One of the interesting things about the balance sheet of a company in the third world, especially the CPI (China, the Philippines, and India) countries, is that the ratio of capital expenditure to labor expenditure tends to get reversed compared to Western corporations. IBM bleeds on its labor expenditure because of its wage structure, whereas for Infosys, the cost of capital in some ways is not cheap.

First of all, the cost of capital in India is not cheap, which is why Indian companies have to rely on equity markets and their performance is so important. The second aspect is that capital items — such as fiber optics, access to high-intensity capital items like high-end computers — are not cheap in India. If you control for capital and the nominal cost of the rupee and the dollar, it’s actually cheaper in the United States than in India. So don’t you think that for capital intensity, going forward, unless the Indian economy is willing to unleash significant reforms, both Wipro, and Infosys and other companies will be handicapped?

Mass: Our conclusion is that the cost of capital for those companies, particularly Infosys and Wipro, is in the range of 11% to 13%, which in fact is in the same ballpark or even lower than what we calculated for Accenture, which we estimate is in the range of 16%, or Capgemini, around 15%, Unisys, at 13%. Our conclusion would be that the cost of capital is, at least to a first approximation, very comparable.

Aron: But there are two elements to the cost of capital. One is the cost at which it is acquired from the capital markets [that’s what Mass was talking about], and the other is the cost of capital expenditure on the P&L statement. So if you think about controlling for the nominal value of the rupee and the dollar, it does appear that it’s cheaper to buy capital-intensive equipment in the United States, as opposed to India. For instance, if you’re talking about a high-end fiber-optical router, it could be from 28% to 40% more expensive in India. Some other examples include the cost of bandwidth, of electrical power-generating equipment, and so on. One of the advantages that Indian companies have is the lower labor-cost structure, but a lot of them have realized that capital equipment is more expensive. This is partly because of the policy regime, and partly because India is only now emerging into the global economy. There are so many examples. For instance, when Lehman Brothers outsourced many of its operations, the company actually did a turnkey job of taking entire networks of computers and routers, and physically shipped them to India rather than buying them there.

Schroth: But wouldn’t American companies that are buying companies in India run into the same problem? If Perot, EDS or others like GE are opening up centers, aren’t they paying the same prices as Indians, and therefore it’s basically an equal, offsetting amount?

Aron: Yes and no. If you look at IBM, it has 80,000 employees, of whom about 17% or 18% are in India, a low-cost regime. For capital acquisition, it’s not that 18% of IBM’s capital equipment is acquired in low-cost regimes. In fact it’s less than 5%. So a lot of these companies are smart enough to say let’s look for labor arbitrage in India, but not necessarily for very capital equipment-intensive work. That’s true for Accenture too. So many companies would buy capital equipment in the U.S. and actually physically ship items and products to India, like many of the outsourcing companies have done. And others would simply say that this is not the best place to look at a capital intensive operation. In fact Singapore would attract more of those very high-end capital intensive operations. IBM itself has a very big operation in Singapore. How far do you think Indian companies will be in some sense handicapped in the absence of changes in the policy regime?

Unnikrishnan: In conversations with Indian companies’ managers who are based in the U.S., there seems to be a bit of a shift. They don’t think of themselves as Indian companies; they’re thinking and acting globally now. So it’s not just the U.S. companies that have undertaken some types of arbitrage. I think that Indian companies are also starting to take on similar strategies. This whole push into China is one area in which they’re starting to think about labor-cost arbitrage in a much more global perspective. I was talking to somebody who was the head of Convergys [a major call center operator in India] and he talked about having initially got a lot of capital equipment in the U.S. and moving it over to India. In a year, they did the math and found that if they had really thought about sourcing differently, they would have just stuck with Indian sourcing. So I think there might be some critical aspects of capital investment that still need to be made across global lines, but as far as many of the types of businesses that we’re talking about here, you can see that some of the biggest components of their costs really still remain people. So they have a bit of a bump there.

Aron: So the labor arbitrage may be strong enough to override the capital component.

Unnikrishnan: Exactly. One of the things we bring up in the study is the fact that part of the challenge for the Indian companies is to try and understand what their value-added is, as other companies start to see the value of moving their costs down. They need to be thinking differently about their own business models and their own business capability. At that point they might have to move to a higher-end kind of value proposition. At this point they have to reassess where they’re spending their capital.

Aron: That gives us the perfect segue to another question. As you point out, the relative value of growth means both margin and growth. So let’s step away for a moment from the capital intensity and come back to specifics.

If you look at the technology services industry, you can break it down to a few layers. The bottom-most layer is a very hardware-driven business in which there has been convergence onto a few standards. This is the business of actually producing computers, components, routers, and networking equipment. The middle level consists of a bunch of services, like applications development, applications testing, and documentation. The top level is what falls into the grab-bag of consulting, but these are really customized services.

If you look at the margins where Indian companies are really strong, it’s in the middle level. They are almost absent from the hardware level, since for a variety of reasons manufacturing is still not competitive in India. It’s in the middle — the application development design, testing code maintenance — where Indian companies are really strong. They are now trying to upgrade, to some extent, to get into consulting services. In your mind, if you wanted to divide this (the nature of consulting services) up, you would say that at the top is diagnosing a problem and prescribing a solution, which is what management consulting firms do; devising the solution, which is what process consultants and management consultants both do; designing the solution, which is where Infosys, Wipro, and TCS come into play; designing, developing and transferring the solution, finally operating the solution with BPO (business process outsourcing). What do you think the prospects are for Indian companies to move into the consulting end of the spectrum?

Schroth: There are two pieces to this answer. Focusing on India is fine, but I have to bring the U.S. into this, too. We did not include IBM, Hewlett-Packard and a couple of others in the study because their businesses are broader than outsourcing and we could not separate out the financials of the outsourcing portion. But when you look at EDS and its acquisition of AT Kearney [management consulting], or at Index, where Tom Gerrity, Wharton’s former dean, came from after it was acquired by CSC [Computer Sciences Corp.], both these acquisitions failed in the sense that the firms that were acquired were never fully absorbed and internalized inside the organizations that took them over. I think we should get into some detail about what consulting can and should be within the outsourcing context.

At the high-end strategy level, what one might call a more pure kind of consulting — where you’re working on a strategic business problem — there is a big conflict of interest that develops working inside of an outsourcer as a consultant. You’re hired to have an objective opinion about the particular issue, and the margins that you’re generating as a consulting organization would be fine for some smaller or middle-sized firms, but for an outsourcer, the margins really don’t make that much of a difference. Instead it’s the total revenue for the year or the total contract value and duration.  In almost every case, the consulting organization never meets the total contract value expectations of the parent outsourcing organization, therefore most consulting groups inside the larger outsourcing organization are left to survive by rationalizing themselves on helping drive and close outsourcing deals. The pressure to generate outsourcing revenue streams becomes a heavy weight on the whole consulting arm, especially at the higher-end strategy levels. Such arrangements seldom work in the end.

Aron: Let’s look at an example of this. When you say working from inside of an outsourcer, you’re thinking in terms of a company like Accenture or EDS as opposed to a company like McKinsey or Bain or BCG (Boston Consulting Group)?

Schroth: That’s correct. And as that model continues to evolve inside, when there is a need for that consultative service, one of the problems that starts to happen is that you get into a traditional dichotomy between a high-end consultant and a margin-driven individual who may be working on the outsourcing deal. So you bring in a consultant, a partner-level person at $5,000 to $7,000 a day, and the rates that they’re currently paying for a senior-level individual in most corporations are probably somewhere between $800 and $1,200 a day.

The first thing that happens is that the organization that is trying to contract with you (the sourcer) starts to ask what this is all about. With you as an outsourcer, these rates are totally out of line. And the pressure internally, on the consulting arm, start to feed back as “You guys have to eat this additional cost because this is going to kill our relationship with a huge client. We have to get these costs down to do this consulting work.” And then, once those costs begin to be taken care of, there is an added pressure incentive of knowing, “The outsourcer really wants to see outsourcing come out as a result of this work or a relationship that quickly leads to outsourcing.” So you have this entire conflict circle going on.

In India, for the outsourcing side, I agree with your point about the processing side. I think there will be a forward, upward movement into some of the consultative services like ERP (enterprise resource planning). Some of the ERP operations still require good financial structures and good financial consulting to go with the implementations, but it’s not the strategy-level elements. So I think there will be a cap level that many of the Indian companies will not want to integrate into their business model. And I believe there will be a shedding of the U.S. companies’ high-end consultants that are housed inside the outsourcing companies.

If you look at many outsourcing organizations, most of the high-end consultants are no longer there, but their ERP consultants are still in operation. They separate these things out very clearly. I think the market is demanding, under cost-of-service pressures associated with the outsourcer, that these things start to balance. I do see the McKinseys, Katzenbachs, Bains and other organizations of similar nature clearly understanding that the outsourcing arena is becoming more strategic. They stayed away from most of this work in the past because it was never a strategic issue. But as outsourcing moves from a transactional basis into blends of strategic issues as well as labor arbitrage, the complexities have moved up to a higher and more strategic level. To make this work I think there will be more partnering in the future between the consulting firms and the outsourcers in order to tackle many of these more complex and integrated problems.

Aron: So let’s summarize the two issues you have raised: The first is the cost structure of the consulting business. On the one hand, you have the $5,000 to $8,500 a day person for an engagement manager or a partner-level person in a management consulting firm. On the other hand you have, let’s say, a $650 to $1,300 a day person working for the outsourcer.

Schroth: That’s right, and there’s another thing that I should mention. These are all accounts that are primarily managed as P&Ls. And so when you invite an “outsider,” to assist, even though they’re inside the outsourcing firm, to come in, there’s a risk that someone might do something to jeopardize the relationship with the account.

Aron: There are companies that wrestle with this all the time, such as IBM and Accenture. IBM, especially, is trying to fan the fire. It is trying to offer the kind of services that, say, BCG, McKinsey, or your firm might offer, but they’re also trying to offer the most system, ERP or CRM packaged services, right down to designing and developing. That is where they’re trying to ramp up and beat (their Indian competitors) in India. For example, consider IBM’s acquisition of [outsourcing services provider] Daksh to get into the BPO business in India.

Meanwhile, some of the Indian companies are trying to build up a consulting arm. I’ve studied this fairly closely. Right now it’s what I call embedded consulting, which is a designated package that needs to be customized along with some understanding of accounting and finance. It is not generic strategy consulting. They don’t want to grow generic strategy competencies.

Now, there are two debates going on. One group says the consulting part should be housed inside the company, part of firms like Wipro or Infosys. The other says there should be a capital holding structure, but the consulting operation should be a separate company for exactly the reasons you mentioned. Do you think this brings them close to strategy consulting — which is not related to the technology work they do? It’s no longer embedded consulting. Do you think it will work, or is this too far from their core competencies? And if this is so, what kind of governance structure you think they should have?

Schroth: I think this will be a tough journey and it depends on which markets you’re trying to isolate. At the high-end strategy consulting level, for the Indians to move into the U.S. marketplace in particular — or to compete against established, world-class players like McKinsey, BCG and Bain — there are very few that have been able to differentiate themselves strongly enough to sustain any kind of presence or significant long-term growth. The history just does not point to that as a successful place. There are also some significant cultural issues coming into the U.S. market. The presence is dramatic, and it’s very different to have senior level presence in the boardroom,  at the chairman level, or at the CX (chief executive) level than it is to have strong relationships at the operations level. This gap is a formidable cultural and socialization issue that needs a lot of study. I think that the Indian organizations will also find that they will have to separate these things out to avoid a conflict of interest. I’ve seen Index and its partnership with CSC. And it was very harmonious, but at the end of the day, the question was, “Who’s driving the revenues?” The differentiation between the Harvard, MIT and Wharton graduates and the remaining part of the company was just so much that the whole thing buckled.

Unnikrishnan: And this may not seem important, but in Katzenbach Partners’ experience, when you have parts of organizations doing such drastically different businesses with drastically different economics, it builds disharmonies within the organization that require a great deal of astute management and organizational design to resolve. We’ve come across a few companies that recognize this, and even some of the management aspects between voice-based business in call center work, and other process outsourcing. It builds into business such different economics that a lot of Indian companies are going to have to start thinking differently about their management capability and leadership mix in the coming few years.

Schroth: I would also say there’s another level of consultative work going on that’s fairly quiet right now but that’s starting to evolve a bit more. And that’s at the level of [firms like] the TPIs, and the Everests and the Equaterras.

Aron: Peter Bendor-Samuel [founder of the Everest Group] and I have done some research in this area. Everest is doing what I could call specialized midwife consulting, in some sense.

Schroth: I think they’re going to expand those positions — they can’t stay stable in there. I think they will head more upstream. At the same time, that’s the territory that McKinsey, Booz Allen Hamilton and BCG maintain.

Aron: They’ll actively defend their turf — they’re not going to cede it over. Especially since now, as you point out, they see outsourcing as a strategic business.

Schroth: At TPI in particular, they were just recapitalized last year by Monitor, and I’m sure that’s not by accident.

Aron: That actually points to two trends that are taking place in the American marketplace. I think the cultural barriers are enormous for Indian companies to get into the so-called high-end category” consulting. I think that some of the Indian companies have underestimated the barriers. But to go back to the American market for a moment, many of the management consulting companies are taking a two-track approach to this. They are saying to their clients, “We will do the strategy end of things — we will help you identify processes, we will help you identify cost structures, contract structures, and other services.” But then we will have understandings and loose alliances with Indian and Chinese companies. We will also point you to people who can actually do the coding, execute and take the processes and run with them. They’re beginning to build these loose alliances. I see there are two questions here. First, how do you see that panning out? And second, do the Indian companies run the risk of losing control of the ownership of the customer relationship if somebody else midwifes the contract?

Schroth: When you talk about the ones who are running a sort of general contractor role, are you thinking of the IBMs and Accentures of the world?

Aron: IBM and Accenture are trying to source these services as much as possible from their own resources. So IBM would send in their services team, would do their consulting, they would do the appraisal, and they would come in and say (to their clients) this is what the solution looks like. If possible, they would even develop it, and if the clients need it, then they would provide operations and BPO support services, which they could hand over to Daksh for that part of the business. Accenture would like to do the same thing, but they probably don’t have the same portfolio depth as IBM, which has greater span in the stack of services that I outlined earlier. I find, when talking with these people, that they are trying to acquire competencies where, for instance, they’ll walk into a large insurance company and would strategize, tell them — diagnose — what is wrong and put a solution into place. They would say, “By the way, if you would like to have the technology part of it taken care of, here are some pointers, and some companies that are particularly good at delivering this.” And they could even go one level lower and say, “At some point in the next 18 months you could think of moving a lot of FTE (full-time equivalent — a proxy for headcount) offshore, that is the BPO part, and here are some of the things you need to keep in mind.” How do you see that playing out?

Schroth: I think there may be some limitations for the high-end strategy companies regarding how for they want to go in this area, versus continuing to be a general strategy organization. Many of these specialty areas will probably work themselves out in many different ways. McKinsey, for instance, has never particularly been strong in some of the technology areas. And as you begin to push deeper into some of these areas that require operational understanding, the question is how much will the parent company tolerate as part of their image? Because there are a lot of risks associated with this particular area of outsourcing. Deals often fail, there’s a lot of potential risk and liability attached to it — more so than many of the situations in which they’re currently engaged. There may be some collaborative efforts, but I think it’ll be a slow transition for the McKinseys, BCGs, and Bains to build these partner alliances and relationships and still maintain their independence, which is primarily why people hire them.

Aron: So there may be some conflicts of interest. But you do notice that McKinsey has been fairly visible in releasing a series of reports, on outsourcing, on BPO, on India, etc.

Schroth: And Bain and Booz Allen Hamilton have been doing the same thing, being very aggressive in trying to build this as a practice area. I think part of this is in order to hold their position as strategy consulting firms, they absolutely have to have a viewpoint about global outsourcing. On the other hand, whether they will be involved in the directional nature of suggesting companies or recommending — that has never been a traditional role that they’ve played before. And it’s probably going to run up against their objectivity role pretty quickly.

Aron: This brings us to the threat to the Indian companies. Their real weakness is in business development and relationship management. They’re really poor — I don’t mean in skills, but the ability to wear a suit and talk to the CXO’s office. So it’s double-jeopardy now. One point is that they don’t do the relationship management and talking the strategy talk very gracefully. And there is likelihood that so-called mid-wife” firms like Everest could take ownership of the customer relationship.

Schroth: I think your observations are dead-on in terms of the relationship and the awkwardness of moving into and maintaining these relationships. I actually think that there will be more social prejudice continuing to grow as these global sourcing situations occur. I can see that in the U.S. too. If companies pare back employees in places like Texas, I can believe that an Indian company coming in to do business is not going to be well received. Everest has been doing a lot of publishing, though I haven’t seen a lot of their presence; but clearly Equaterra and TPI are thinking about those relationships a lot more. Because the degree of outsourcing is huge, if you look at the ABN Amro situation. I think TPI ran that deal. They step out after the contract has been done and they don’t stay around to maintain the relationship very long. That is an area where you’re going to see a huge expansion and active growth because those are deep relationship owner pieces. And they don’t want to let them go any more than BCG or Booz Allen or Bain does.

Unnikrishnan: There may be a twist to this, since many of these midwife organizations have tended to succeed because they set up contracts that are very favorable to the client but are not all that favorable to the vendors. Our point of view has been that if you really are thinking of these vendors, and companies are trying to outsource as people getting into long-term relationships, then that sort of attitude may be strategic, particularly if they want to retain that level of client relationship. The point of being so squeezed in your contract is that some of these outsourcing companies will not be able to take the expansive, strategic vision that they’re capable of, because they can’t put the money or effort into evolving with the client. So in order for the Equaterras and TPIs of the world to retain any credibility, they have to make sure that the vendors are actually also able to succeed over a long period of time. There will be some dynamic changes in the way these companies behave and interact with each other in the marketplace.

Aron: But if you look at the gross margins, between 25% to 38% in technology, and an average of between 18% to 32% in BPO, that’s not much of a squeeze.

Unnikrishnan: But how much of that is across the board; or only for certain companies?

Aron: No question, it’s true for about 10 or fewer companies. If you go down below the level of firms of the size of Cognizant, those margins can shrink to 11% or 12%. But do you think the TPIs and Equiterras and Everests don’t really have an understanding that goes beyond the top dozen outsourcing companies in India, China and the Philippines?

Schroth: I think they monitor all those tightly. They tend to work at the larger deal range, about $50 million and above. But they do maintain monitoring of all those other outsourcing situations.

Aron: Do you think consulting in and around outsourcing–helping clients to source business globally, find partners, choose regions — will become specialized consulting, the way that things like automotive design and apparel and advertising have gone?

Schroth: Katzenbach has a particular focus around organizational dynamics and team development and other areas of pride in their work. And I see that these areas are real specialties. And if you look at the top reasons deals fail, you have the technical architecture that clearly gets laid out in the designs, but no one is paying attention to the organizational and philosophical design of the way the company operates. If you were to go to most CEOs of major organizations and ask them to give you a diversity network, of what they used to look like 10 years ago, to give them a sense of what their current diversity looks like, they’d probably go to their human resource person and produce a diversity diagram. It would probably come out of their current employee base.

But the reality, as we all know, is that a huge percentage of those corporations have now outsourced a lot of this work. And their representatives on the other end of the phone aren’t in those diversity numbers. So when you step back and really look at all the outsourcing relationships they have, and then look at whom the outsourcers have outsourced their relationships to, you would begin to fid that the diversity of the company is some kind of 2x multiplier of what they currently believe it to be. That is a strategy, something that is going to have to be managed, not only for pockets of diversity, but for the structural architectures of the organization, the principles under which it will operate, the purchases of mergers and acquisitions. That’s the big picture. It’s more than just moving this stuff offshore.

Unnikrishnan: I would add that there’s not just the idea of what the number is like, but also what capabilities you have within the organization that aren’t being thought through. Does this increased diversity, and this access to understanding a different culture mean that you could potentially be much more effective at making incursions into China or India? Can you use your outsourcing partner as a way to strategize differently in the other markets? I think companies will get to this point pretty quickly. Right now companies think of outsourcing as a method of cost control, but they’re going to get to a point where they’ll be thinking pretty deeply about the strategic advantages.

Schroth: Going back to your consulting question, I think that’s where the line will be drawn for the McKinseys and others, because that’s really interesting and hard work. That’s the fine line that separates the people who go to those kinds of organizations, versus the more mechanical kind of work that might be found in other kinds of consulting work.

Mass: I believe that there’s a large intermediate category that Accenture is probably pretty good at. Where they will do a very quantitative-oriented analysis, say on retail loss prevention. Or something that’s vertical-specific that has to ultimately tie into a CRM system. That work is very IT-centric but is also quantitative, but stops short of being corporate strategy. It seems to me that is an area that is ripe for the Indian companies.

Schroth: I think that’s where the BPO side of the Indian companies will start to evolve. That’s where the lines will be drawn between the high-end strategy and the next level of consultative work.

Aron: You mentioned the BPO side of many of these technology majors. Even within BPO, I find that companies that tend to specialize have much higher revenue per employee. If you consider companies like Progeon, which is an arm of Infosys, or Wipro BPO, and contrast this with companies like Office Tiger in India, which tends to specialize in expert, judgment-driven services–about 50% of their deadlines are one hour or less. And they — Office Tiger — directly communicate with their clients through several channels that are both real-time and quick review and response. Don’t you think that the sun is slowly setting on the commodity BPO (the non-Office Tiger kind)?

Schroth: There’s so much of the basic BPO to be done, that there’ll be plenty of business to keep growing. The specialized knowledge areas will be much more about branding because I watched — back when I was with the Marriott Corporation, you could get a Marriott hot dog and it was never appealing because they were just Marriott hot dogs. But the company finally learned that the branding was a big deal, and so they began to develop relationships with Sbarro and Nathan’s and Starbucks etc. Now you’re still at a Marriott, but you’re dealing with a branding element around that. I believe that these specialized knowledge sides are going to be an area built around branding. Companies will start to do relationships and partnerships with these big multinational outsourcers. And these multinationals will actually co-brand to get these specialized knowledge areas up and give confidence to the consumers.

Aron: So let’s look at the situation as it stands now. The Accentures and IBMs are not yet at the high-end, expert-judgment driven BPO work. The firms that are doing a great job of it, like Office Tiger and a few others — like Hewitt Associates in the banking research area — are the independent players who came out of that industry. They knew exactly how to cater to that industry. Do you think Accenture and IBM will ever be there?

Schroth: I think they will, but they’ll do it with brand-name partners. I look at this a lot like the evolution of the dot-com industry, which had to have all these startups and had to go through mistakes, and few of them are around anymore. But ultimately the big folks got in there and changed them around until they got the branding correct. So in an IBM-Citibank relationship, not only will IBM do the outsourcing, but will partner in new ways to provide knowledge under financial systems. It’s not only a powerful relationship, but it cements the outsourcing relationship for IBM.

Unnikrishnan: I wonder whether the whole issue around the BPO piece, that you didn’t have in the Internet boom, was the SEI [Software Engineering Institute at Carnegie Mellon University] ratings, and quality metrics that are being leveraged pretty effectively by even the smallest players. They’re establishing a level of credibility through that. There are brands emerging that are not about to reach out to McKinsey or Accenture, that are driven from other countries. (After the publication of the study) I’ve been receiving e-mails and calls from small and large outsourcing companies in other parts of the world, asking if we want to partner with them. It won’t just be about the small players reaching out to the large branded names–they’ll figure out new and interesting partnerships. Their vertical kind of strategy is what’s happening now, and I think there will be few models emerging.

Knowledge at Wharton: Thinking about China, who would have thought a few years ago that Lenovo would have made such a big impact on the PC market by acquiring IBM’s PC business and buying its way into the market through sheer access to capital. As you look at situations like Bharti Telecom, which allowed Warburg Pincus to exit $500 million from India, it shows the strength of India’s capital market infrastructure, even though its physical infrastructure is nowhere comparable to China’s. Do you think that the branded Indian BPO companies will be able to get enough access to capital that they might contemplate some strategic acquisitions in the consulting field?

Unnikrishnan: I’m not sure that they’d have the access to capital to go with the big players. But a lot of them are doing some strategic acquisitions, acquiring market, although they really haven’t gone into the consulting market.

Schroth: But I still believe that evolving a global brand takes an extended period of time. One of the things we’re describing is what Google’s doing right now. It would be thinking like this. If EDS has these kinds of conversations, the market might find it interesting, but still wants to know if the company can manage its margin. So right now, this is what differentiates the positioning that the Indian companies have, if they take advantage of it.

Mass: Could Infosys mobilize the capital? Yes, today they’re sitting on $700 million of cash, they have no debt, and a very lofty valuation that they could use for acquisitions.

Schroth: But who will companies like Wipro and Infosys work with to help them change their culture, which somewhat mirrors the U.S. outsourcing culture? Until now they haven’t been aggressive, but now that they’re playing in the world scene, I think they’ll have to spend some of this money on getting their own strategy pulled together. A lot of the people they’ve hired in the U.S. are traditional outsourcing people that have come from companies like EDS. If they don’t make that move from a margin-driven strategy to a growth-driven one they’re going to give the American outsourcers time to readjust their margin bases. Until they fight that battle and win, they’re not going to be able to go anywhere. This could be their Achilles heel.

Knowledge at Wharton: So when a company focuses on margins, what kind of behavior does that drive and how does that differ from the behavior of companies that focus on growth?

Mass: When we looked at the relative value of growth through a spectrum of companies we found that a variety of firms — EDS being one — will have to focus on rebuilding margins. And those companies are under intense pressure to rationalize their cost structure. They will be prone, in the critical third and fourth years of outsourcing relationship to be thinking of how to get costs out, rather than how to provide the extra measure of satisfaction to the customer. And that is what the Indian companies have the potential to do, which I don’t think they’ve done yet. Wipro has 23% to 30% operating margins, so they ought to be investing very heavily in innovation and in defining what could be the next game in the outsourcing business.

Schroth: Just to emphasize this, Google received a score of about 60 on the RVG, and Infosys received about a 50. If you sat in a room with the main people from Google, and from Infosys, you’d get a definite different feeling about progressiveness, growth, and the thinking and the dress that that they’d wear to talk to you. I’m suggesting that’s going to be the tough barrier because in a sense the market is defining those two companies as some of the highest growth potential firms in the marketplace. Yet Google is performing quite admirably, whereas I don’t see Infosys having anything like that shaking in the market. They probably have a limited window in which to rethink themselves, but also to rethink the culture.

Unnikrishnan: I’d say that Infosys and Wipro are very different organizations but both have to think this through. Infosys has a very corporate environment, while Google is off the wall and different. And Wipro’s ownership structure doesn’t make for a culture where people are trying to push for entrepreneurial thinking because they actually think they’re going to get the kind of payback they would in an entrepreneurial environment.

Aron: Why did Infosys receive a multiple of 50, but Wipro receive a 25? What’s the difference between the two?

Mass: In terms of their relative value of growth, the number one driver is the margin differential. Infosys is more in the 30% operating margin range while Wipro is in the 23% range.

Aron: Infosys gets a lot of its revenue from BFSI (banking and financial services including insurance). Wipro is more diversified. Does that make a difference to the relative value of growth dynamics?

Schroth: The markets have taken that into account already, which explains the RVG differential.

Aron: The advantage in a sense that India enjoys over China is the English language. There are many disadvantages — notably India’s telecommunications and other business infrastructure. I would say in about 15 or 20 years, couldn’t China catch up and overtake India in the services industry?

Unnikrishnan: Possibly. But as an article in Crain’s pointed out the other day, there is the issue of the rule of law. There are some serious concerns about how intellectual property is managed (in China) and that seems to be as big a strategic issue for companies trying to collaborate with China as dealing with the English language or infrastructure.

Aron: But that said, there is a lot of work that is not IP sensitive. I would say that more than 98 or 99 cents on the dollar of BPO work that gets done is not IP sensitive. It really doesn’t matter where your call center operator is taking orders for Land’s End clothing. Don’t you see China overtaking India in all those areas?

Mass: I think there is going to be a shift, whether it will be in China or Latin America, or in Eastern Europe. China clearly has the population base and it appears as if they’re going to make the necessary investments in their infrastructure. Clearly the American companies have moved over there and are trying to develop key relationships. But there is a deeper question: a lot of this is predicated on world harmony. I think there will be reluctance to feel as comfortable in the Chinese compared to the Indian marketplace. Language is one factor. There also tends to be a closer relationship and trust in India, whereas the Chinese situation is more volatile. Many of those long-term big pieces are still at risk. Business will measure that risk and will decide. That being said, I think the Indian companies will try to develop deep relationships with the Chinese to be able to take some of their cost advantages further with Chinese labor.

Aron: Knowledge at Wharton has long argued that you will see several regions emerge, including Easter Europe as a near-shore alternative to the European Union, also to diffuse some of the cultural reluctance to send jobs to cheap foreign labor markets. North Africa and Mauritius will play the same role for the Francophone market. For the United States, near shore alternatives will be places like the Bahamas and the Caribbean, and also Brazil. What are your thoughts about the variety of regions emerging? Will the global sourcing of services in some sense begin to resemble the global sourcing of products?

Mass: I think that proposition makes a lot of sense. ACS, which is one of the high-performers in North America, has a very highly developed stage of maturity model, to know which processes they can take to progressively more remote, low-cost locations. So they start out in Salt Lake City and they eventually end up in places like Ghana. I think there is a logic that says you can have varying degrees of specialization and differentiation based on having a smart owner who’s able to parse out those activities over time. Back to China, it’s very strong in automotive but has been less focused on the services areas. It probably could do it, but it’s not clear to me if they will do it.

Unnikrishnan: They could, but the transaction costs of moving from one source to another are a big piece of the puzzle, especially given the history of the simplest outsourcing projects. The first year is full of pain because you’re taking talent and scaling them up to perform at a high level of efficiency or quality or other issues that differentiate that service. But that first year of pain is not that bad if you’re talking about a shirt that can be manufactured in Taiwan or Latin America. The critical aspect is human memory that’s required in dealing with some of these (higher level) processes, which will add transaction costs. That will make it a little more difficult.

Schroth: There is a phenomenon around the strategy architecture that’s related to pulling this all together. I think we’re going to see more high-end strategy practices moving toward a global process optimization where they will begin to really understand that the ability of a particular area to handle a particular kind of sourcing is probably superior to another area. And we’ll ultimately see — rather than a generalized kind of processing — some of these specialized processing areas start to emerge. Like in insurance processing or claims processing, that become kind of independent, stand-alone centers of excellence within the global process architectures. And that’s an evolution that many of the Indian companies will arrive at. Infosys is already pretty well positioned. If they start to move to a different vertical, they could continue to capitalize on that one optimized industry they’re in, and continue to optimize it while moving to another.