Infosys, TCS, TechM: Valuation comfort alone unlikely to drive IT rerating; 4 things to watch

Kotak Institutional Equities in a note said valuation comfort alone is unlikely to drive a rerating for IT stocks, saying the recent sell-off reflects fear around the durability of the business model in an AI world, not just near-term earnings risk.

The brokerage said the market is discounting disruption far more than current evidence supports. Growth rates to perpetuity implied at current stock prices for incumbents stand at 2.7-3.8 per cent and 6-21 per cent during the high-growth phase for challengers, it said adding that continued stock price correction can provide an attractive entry into quality challengers. For now, stocks such as Tata Consultancy Services Ltd (TCS), Tech Mahindra Ltd (TechM) and Infosys Ltd offer reasonable value, Kotak said.

For sentiment to turn, Kotak Institutional Equities said the IT firms will need to demonstrate visible and sustained growth acceleration. It said a moderate improvement at Cognizant and a minor improvement in Capgemini have indicated growth acceleration in a year of peak GenAI headwinds. 

"Healthy guidance from the likes of EPAM and Globant will further help halt the narrative of terminal decline. The near-term challenge is that CY2026 will likely see higher AI-led deflation as pilots move into production. Whether growth can accelerate in a year of high AI-led deflation will determine the next phase for the sector," it said.

Kotak said it estimates a 2-3 per cent downside risk to growth over 2-3 years from GenAI adoption. This could undergo a change in the case of a few factors. They are:

Productivity improvements 
Higher-than-expected productivity improvements from GenAI models and tools will lead to higher deflation, either from faster progress in models or an increase in the reliability of agents and agentic AI in IT services tasks. For now, Kotak expects 16 per cent revenue deflation on existing services spends on a gross basis over three years. This is based on estimates of productivity benefits in various segments.

Lower reinvestment 
Kotak said it has assumed that 50 per cent of the productivity savings from GenAI gets reinvested back into services spends to drive cloud and data modernisation and automation. Commentary from enterprises so far has been consistent with the assumption of significant re-investments, it said.

Spending squeeze
All eyes would be on a combination of a higher spending squeeze on services and overeager vendors. Higher spending on hardware and resiliency in software spends is leading to a squeeze on services, Kotak said. 

"Higher pressure on services spending through strict cost controls and requests for pricing cuts from vendors will create further downsides when combined with enough vendors who are willing to go along with client requests to maintain or gain market share. This might be happening with select clients in select portions of work currently. Expansion of the same to a large portion of the market will be a challenge," it said.

Ramp up of productivity 
Kotak said it has becomes a key medium-term priority for frontier AI labs. Its expectation is that frontier AI labs after 1-1.5 years will deprioritise software engineering and focus on other sectors such as healthcare and finance. This will lead to lower productivity increases in software engineering and an increase in AI for business use cases. On the contrary, a continued focus on automating software engineering and broader IT services beyond 1-1.5 years will present additional downside risks.