Indian IT Stocks Face Capped Returns Amid AI Disruption
Despite currently inexpensive valuations, returns from Indian information technology (IT) stocks are likely to remain limited until greater clarity emerges regarding artificial intelligence (AI) disruption. This is according to a recent analysis by domestic brokerage MOFSL.
The firm noted that the latest quarterly earnings reports from IT services companies did little to alleviate concerns about sector-wide disruption. A significant 40 percent of companies missed revenue estimates, while another 40 percent delivered in line with expectations, and only 20 percent managed to beat them. Although 66 percent of IT firms met or exceeded margin estimates, MOFSL highlighted that fundamental questions about structural demand drivers persist.
Valuations and Market Pressures
Tier-1 IT stock valuations are trading approximately 20 percent and 31 percent below their 10-year and 5-year averages, respectively. Specifically, Tata Consultancy Services Ltd (TCS) is trading around 40 percent below its 10-year average, and Infosys Ltd is about 26 percent below. In contrast, HCL Technologies and Tech Mahindra are closer to their decade-long averages.
MOFSL indicates that returns are likely to stay capped until deflationary pressures subside and new, concrete AI-led implementation use cases become more prevalent. The brokerage anticipates renewed pressure in the fiscal year 2027 due to upcoming wage hikes, increased AI investments, and the ramp-up of large deals. Moreover, pricing pressures in a subdued demand environment, coupled with ongoing deflationary trends, could further impact profitability.
Margin Outlook and Strategic Shifts
While Q4 margins largely met or beat expectations, aided by favorable currency movements, workforce rationalization, selling, general, and administrative (SG&A) efficiencies, and improved productivity, the outlook remains cautious. Rupee depreciation against the dollar provided a substantial translation benefit, with 10 out of 16 tracked IT firms reporting sequential improvements in EBIT margins.
However, the brokerage believes the generative AI (GenAI) curve will remain margin-dilutive in the near term as significant investments are made, but monetization strategies are yet to fully materialize. If exchange rates stabilize, incremental margin expansion could prove challenging, with margins expected to remain largely flat across the industry over the next 18 to 24 months. Any meaningful margin expansion from this point, MOFSL suggests, will likely stem from workforce productivity improvements rather than revenue growth.
Preferred Picks
MOFSL continues to favor bottom-up plays within the sector. Their preferred large-cap pick is Tech Mahindra Ltd. In the mid-tier IT segment, they favor Coforge Ltd and KPIT Technologies Ltd. HCL Technologies is also viewed positively, with the firm noting its preparations for the next phase of growth despite a short-term miss on growth guidance.