In late July, rumors swirled that Infosys Technologies might be readying a takeover offer for Cap Gemini or another major tech-services player in the US or Europe. So on July 25, when the company alerted the press and the markets that it had a major announcement, there was a great deal of anticipation.

Instead, Infosys [Get Quote] unveiled a $250 million outsourcing contract with Royal Philips Electronics of the Netherlands. It was an acquisition of sorts, the company said, at least of the outsourcing centres that belonged to Philips. "We're taking the model to a newer level," said chief executive Kris Gopalakrishnan.

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Landing a new contract certainly isn't bad news, but the development was somewhat deflating for those who believe that Infosys needs to redefine and reposition itself in the multibillion-dollar arena for global outsourcing services. In fact, Infosys and other Indian outsourcers are facing a raft of competitive challenges that will require some dramatic new strategies.

Adversities add up

True, India's biggest outsourcing firms continue to rake in the profits, at least judging by the latest earnings season. The top five players -- Tata Consultancy Services [Get Quote], Infosys, Wipro [Get Quote], Cognizant, and Satyam [Get Quote] -- reported robust profits in the quarter ended June, 2007. And executives generally forecast strong growth ahead.

"We're very happy with having beaten the forecast," said CEO and managing director S Ramadorai of the $3.1 billion Tata Consultancy Services in Mumbai. "TCS, as the leader, is doing well." Ramadorai predicts $60 billion in tech-services exports for the industry by 2010, nearly twice the current $35 billion, plus $20 billion in revenue from domestic business.

Yet behind this show of supreme confidence lurks deep unease. A confluence of adversities is at play. They include an appreciating rupee that is cutting into earnings, a severe shortage of qualified talent at home, and a cap on H-1B worker visas to the US, along with pre-2008 election protectionism threats.

Diminishing returns

On top of that, there is the end of preferential industry tax benefits at home and the growing success of multinational competitors such as Accenture and IBM on Indian turf. Perhaps most challenging for the Indian players is the pressing need to move up the ladder into business consulting, a domain that companies such as IBM have dominated for decades. Indian outsourcing firms need to invest heavily to secure a position in this arena, and that will erode their fat profits, at least in the short term.

For the first time, industry insiders are asking: Is the outsourcing game over for Bangalore? "The Indian IT companies have had an unusually long run in profits and growth," says Siddharth Pai, partner and managing director of global tech advisory TPI Advisory Services India. But that's "an anomaly," he adds. "As they mature, they can't expect the same kinds of returns."

And mature they must. For the past decade, Indian software-services firms, which pioneered the business of delivering tech services to the developed world from India efficiently and at 40 per cent of the cost of companies such as IBM, have grown exponentially. Revenues exploded from a mere $1 billion in 1997 to $35 billion in 2007.

Outsiders' edge

At first, their multinational competitors such as IBM Global Services, Accenture, and Electronic Data Systems were taken by surprise. But then they joined in the new game, setting up shop in India and leapfrogging by making local acquisitions, hiring aggressively, and offering similar services to their clients. As of June, the three multinationals alone have 100,000 professionals on their rolls in India. That's about a third of the top three Indian players, and the multinationals only began hiring three years ago.

Now that the competition is evening out at the bottom of the business, the battleground will start to move up to the higher end - business consulting and the integration of the offshore and on-site services. Here, the multinationals clearly have an edge. Not only have they been providing consulting services for decades, but they have been doing it across geographic borders, using experienced talent and cultivating long-term and deep relationships with customers.

More important, companies have been investing in research and product development for decades - in 2006, IBM spent $6.2 billion on research and development, and its largest R&D centre outside the US is in Bangalore.

Indian companies, in contrast, have almost no research and development and spend very little on it. They began building their high-end consulting services only two years ago, and all of them have done so organically. Infosys began Infosys Consulting in Fremont, Calif. Wipro has been making small but strategic acquisitions in the US and Europe. And TCS, which has the widest reach with 150 offices and 79 development centers worldwide, says that 3 per cent of its revenue now comes from consulting. That's peanuts compared with foreign rivals.

Lagging the competition

Nor have the Indians attempted to leapfrog into the big league through a major acquisition. "They have to, they should, to get a global footprint," says Avinash Vashistha of New York outsourcing consultancy Neo-IT. Do they lack confidence? Certainly, "the levers and supportive environment they have in India are not available to them overseas," says Kris Wadia, executive partner, global sourcing, at Accenture.

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Indeed, the tech industry in India is so pampered by New Delhi, and so admired by ordinary Indians, that they have been lagging behind the competition. Industry trade group Nasscom recently released a report on the necessity of Indian companies to begin to innovate to survive, and suggested the establishment of an ecosystem for innovation, helped by policy initiatives.

But while India lacks a formal innovation culture, one would never know from the assumed superiority over foreign rivals. Indian firms are simply unable, culturally, to absorb a Western company. Industry analysts say Indian companies such as Infosys are hierarchical, and have an elitist view of their business and suffer from "conceptual Brahmanism," referring to the group at the upper echelon of the Indian caste system.

IBM's India buildup

There's a ring of truth in that. While the companies all employ Indians and some foreigners from across economic and social lines, the top rungs of both Infosys and Tata Consultancy are dominated by upper-caste South Indians. Satyam has a big contingent of employees from the company's native state of Andhra Pradesh. Integrating a Western firm into that closed culture could be problematic. Infosys chief operating officer S D Shibulal dismisses the inability to acquire, saying only: "We are perfectly capable of building things organically."

Companies such as IBM have taken a more democratic approach to building their business. The company began competing with the Indians in the outsourced tech-services business just three years ago, when it acquired Daksh, a call center. Since then, IBM has made plenty of acquisitions in India, absorbed them, and also organically expanded its business.

Today, IBM has 3,000 workers dedicated to research and development at its offices in Bangalore. It is the largest R&D operation outside of the US centre in Armonk, NY, but one that is integrated with all of IBM's nine research centers around the world. Last year, IBM saw a 385 per cent increase in patent filings from its India office.

IBM is already the dominant player at the top end of the tech-services market, with its large and established consulting business, and now it has also mastered the bottom end of the market, which offers low-cost servicing. More important, IBM is the leader in the Indian market for technology services, a market that the Indians have always overlooked.

According to tech research firm Interactive Data, IBM has the largest market share in India, at 10 per cent of the total $3.7 billion market, and customers across the board from the state tax department to the private players.

Missing homegrown opportunities

In fact, IBM is the top choice of India globally. Ambitious Indian corporations such as Bharti Airtel [Get Quote], since 2004, have outsourced roughly $1 billion worth of tech services to firms such as IBM with global expertise. In March, IBM bagged an $800 million, 10-year contract with Idea Cellular [Get Quote], formerly co-owned by Tata, Aditya Birla, and AT&T but now by the Birla group. In the first six months of this year alone, $1.4 billion in domestic telecom deals were grabbed by the multinationals.

According to researcher Gartner, over the next two years, Indian companies in the private and state sector, from banks to the railways, are expected to spend an estimated $5 billion on new technology, all of which will need to be serviced. Save for Tata Consultancy, 9 per cent of whose business is domestic, the Indian players have largely focused on exports and missed the big opportunity in their own backyard.

Nasscom estimates that just a quarter of the revenues of Indian outsourcers are domestic, though it's growing at 22 per cent a year. This year, for the first time though, Infosys said that it would bid for domestic business, admitting that the "home market has reached a level of maturity."

Of course, companies such as IBM in India share some of the same constraints as their local competitors. India is in the throes of a severe talent shortage in sectors from tech to retail to research. Part of the problem is the emergence of new businesses such as retail and telecom in which India has no prior expertise.

But a significant part is the country's creaking education infrastructure, which isn't producing enough qualified engineering candidates who can be productive employees immediately.

Visa restraints hurt

Tata Consultancy, for example, is now mining deep for potential candidates, hiring not engineers, but math and science grads from colleges and putting them through a seven-month training course. "About 20 per cent of our new employees are non-engineers, and that number will increase," admits TCS' Ramadorai. IBM solves the problem by paying higher salaries, but only recruiting engineers.

But what's strictly an Indian headache is the visa situation in the US. Just 65,000 H-1B legal worker visas are issued by the US, a strain on Indian firms that need to send their engineers to work in their US clients' offices. The demand is so huge that for the last two years, on Apr 1, the day that US immigration officials release the quota for H-1B visas, nearly all are snapped up by Indian tech companies.

Why small tech companies aren't outsourcing

With a Presidential election coming up in 2008, visas promise to be a hot-button issue. Already, companies such as Infosys and Patni Computers have been penalised by states such as California for not paying their H-1B employees market wages. The Indians are hiring locally, but it will surely affect their low-cost advantage. The Indians are doing "awesomely well," says IBM's software research chief in India, Harish Grama, "but what are they doing to stay in the game?"

Overcoming a fixation on margins

The Indians defend their position stoutly. "Now, we are in the same position as IBM or Accenture, where people treat you like a partner and consultant, not a vendor," says Ramadorai of TCS. Indian companies, he adds, are spending increasingly on innovation.

TCS says it has developed a full range of services, global network delivery, intellectual property, deep knowledge of different industries, and is starting to invest heavily in innovation, working together with clients. Ditto with Infosys, which has increased its R&D spending to $12 million this year, for instance. Wipro has made R&D a business to be outsourced from people, but that too is not sophisticated, cutting-edge work.

The future, say industry analysts, lies in doing things the multinational way: embracing innovation, consulting, and geographical expansion. To get there, Indian companies must get over their "25 per cent margin fixation," says Ashish Thadani of Gilford Securities, who covers Indian tech companies listed in New York. "Those continuing high margins mean you are probably underinvesting for the future."

With Nandini Lakshman in Mumbai.