IT Sector : Doubly difficult by Kotak Institutional Equities
Doubly difficult
Weak demand has led to underwhelming results across the IT sector. This softness has manifested in multiple ways—margin pressure, increased reliance on balance sheets to drive growth, and heightened aggression in cost take-out deals. While deal TCVs were strong across companies, margins remained under pressure despite wage deferrals and aggressive cost optimization. Stock prices have corrected, and valuations are now undemanding with FCF yields of over 4.5% and payout yields of ~4%. Our top picks remain Infosys, TechM, Coforge, and Hexaware.
Weak quarter across the board with a couple of exceptions
Revenue performance was weak in the quarter, with four of the five large IT companies reporting revenue decline qoq and three of the five on a yoy basis. BFSI vertical held up well and grew 2.7% qoq and 5.7% yoy in US$ terms, while manufacturing, retail and healthcare verticals underperformed. Companies cited various factors for weak demand, including tariff impact and weak discretionary spending across many verticals.
EBIT margins—pressure points visible
EBIT margins declined yoy for the top three players, with profitability pressures visible across the board. While companies have managed to protect margins during weak demand phases through efficiency measures, wage deferrals, and cost controls, the levers appear largely exhausted after nearly three years of subdued demand. Large cost take-out deals are inherently margin-dilutive, and a recovery in discretionary spending is essential to offset this headwind.
Mid-tier companies outperform
Mid-tier companies outperformed their larger peers on revenue growth, a trend that could persist. However, some mid-tier names fell short of expectations, triggering sharp stock corrections. The quality of growth was mixed, with some firms relying on balance sheet structuring to drive numbers. Despite this, we expect mid-tier firms to continue outperforming the large caps.
Deal TCV—strong but not net new for the industry
Deal TCVs were robust across the board, possibly aided by a common large client. Many of these deals are cost take-out or vendor consolidation in nature. However, not all are net new—some involve replacing one vendor with another. In such cases, the client is the net beneficiary, not the industry. These deals are typically price-sensitive and margin-dilutive in the initial phases.
Valuations—not expensive but require demand improvement
The IT sector is at an inflection point. Valuations are no longer expensive, but the health of the business—especially profitability—hinges on a revival in discretionary spending. The path to recovery remains unclear, even as clients need to invest across multiple dimensions to become AI-ready. Execution will be key. We reiterate our preference for Infosys, TechM, Coforge, and Hexaware.
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