Nomura on IT stocks: Transition painful but high cash flow, dividends to create floor soon

Amid the ongoing rout and volatility in the Indian IT stocks led by AI-disruption concerns and on near-term sentiment, overseas brokerage firm Nomura believes that the current sell-off appears to be a case of front-loading of pains. "Transition period is painful but high free cash flows (FCF) and dividend yields (4-5 per cent) will likely create a floor for stocks sooner than later," it said.

Nomura argued that the IT stocks are pricing in extinction of old business models before gains from new business models emerge. Valuations have corrected meaningfully and are now trading below last 12-year averages and at 12-39 per cent discount to last 5-year averages, it said. The outlook for IT sector valuations has been framed within three scenarios by Nomura.

In a structural decline case, significant automation of routine tasks is expected, with revenue facing sustained deflation in the range of 6-7 per cent or higher. Under such conditions, growth rates could slow to 2-3 per cent or potentially turn negative, leading to negligible expansion in earnings and compressing valuation multiples to between 10 and 12 times earnings.

A more stable scenario considers the industry’s ability to successfully pivot towards data and artificial intelligence-led services. In this case, revenue growth could return to its historical long-term averages, enabling price-to-earnings multiples to recover to levels in the early 20s. This would reflect improved investor confidence in the sector’s relevance amid technological shifts.

The most optimistic scenario sees IT firms transforming into AI orchestrators, moving beyond effort-based services to focus on delivering value and tangible outcomes. This shift could enable nonlinear revenue and margin expansion, with valuation multiples rising above the early 20s as the market recognises the enhanced growth prospects.

Indian IT stocks staged a decent recovery on Tuesday after Infosys Ltd announced a strategic collaboration with Anthropic, an AI safety and research company, to develop and deliver advanced enterprise AI solutions to companies across telecommunications, financial services, manufacturing, and software development. The stock jumped 3.25 per cent to Rs 1410.95 during the day.

Its arch peer Tata Consultancy Services Ltd (TCS) rose more than 1.63 per cent to Rs 2752.35 for the day, while HCL Technologies Ltd and Wipro Ltd gained over 2 per cent, while other IT largecaps like LTI MindTree Ltd and Tech Mahindra Ltd gained up to 2 per cent each. IT stocks have dropped up to 30 per cent from their respective 52-week highs.

Another global brokerage firm UBS believes there has been some near term overreaction, but the questions around terminal growth cannot be ignored. The brokers said to keep a close eye on how quickly and effectively the IT Services companies adapt.

Commenting on the free-cash flows (FCFs), UBS said that the current valuations suggest pricing in terminal FCF growth of 4-6 per cent versus 6-7 per cent by investors just a month ago. "Gefending growth requires moving up the value chain beyond just pricing and delivery models," it said.

UBS sees largecaps IT stocks are trading at P/E of 16- 21 times, lower than historical averages across any period for most companies. ""We still believe we are seeing an improving environment in the near-medium term, supported by tailwinds from a macro improvement and acceleration in 'AI readiness' work," it said.