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Higher AI deflation clouds recovery, Status Quo maintained; FY27 recovery fades further

Q2FY27 is likely to remain another subdued quarter for Indian IT, with no meaningful improvement in demand and recovery pushed further out, putting FY27 on track to mark a fourth consecutive year of weak growth. Large-cap IT is anticipated to deliver muted -0.7–1.5% QoQ CC growth, while Tier-II should continue to outperform at 2.5–4.5%, supported by stronger execution, order books and relatively lower deflationary pressure. Persistent macro uncertainty, elongated decision cycles, weak discretionary spending, geopolitical disruption and rising AIled productivity pass-throughs continue to constrain growth. Our channel checks indicate productivity-led pricing/revenue deflation of 50–60%, significantly above our earlier 15–20% assumption; however, incremental scope additions partly offset this, leaving net deflationary pressure at ~20%. We expect this headwind to remain elevated over the next few quarters before moderating thereafter.

We change FY27–28E earnings by -1.4–0.7% across the sector to reflect slower demand recovery, weaker discretionary spending and higher AI-led deflation, while lowering target multiples and fair values by 9–10% to capture weaker medium-term growth visibility and execution risks. We expect incremental AI-services revenue to offset the deflationary impact by H1FY29 in our base case, with an earlier recovery possible if enterprise AI adoption accelerates. While valuation has corrected and downside appears increasingly contained, a sustained re-rating will require tangible evidence of demand stabilisation, accelerating growth and commercial monetisation of GenAI beyond productivity-led cost takeout.

Muted Tier-I Growth; BFSI and Deal Momentum Support Tier-II Outperformance

We expect Tier-I IT services to report muted USD revenue growth of -0.7% to 1.5% QoQ, reflecting weak discretionary spending, AI-led productivity pass-throughs and delayed deal ramp-ups. TCS and Infosys is expected to remain relatively resilient at 0.0% and 1.5% QoQ, respectively, while Wipro (-0.7%) is likely to lag behind. HCL Tech (0.7%) should remain within guidance, while Tech Mahindra (1.2%) and LTM (1.6%) are expected to benefit from stronger deal wins and conversion. In contrast, Tier-II players should continue to outperform, with 2.5–4.5% QoQ growth, supported by healthy deal momentum, particularly in BFSI. Coforge is likely to lead, aided by the Encora integration, reinforcing its stronger growth trajectory. We believe the BFSI vertical will remain the key growth driver across the sector, while geopolitical uncertainty and weak macros are anticipated to caution client decision-making.

Margin Under Pressure as Currency Tailwinds Fade and AI Cost Rises

Margin is projected to remain weak QoQ in the near term, as INR depreciation moderates as compared to the past two quarters, while continued AI investments weigh on profitability, partly offset by internal AI-led productivity gains. TechM is expected to lead margin expansion with ~167 bps QoQ improvement, driven by delivery efficiencies and Project Fortius, while Infosys could see a modest ~40 bps contraction amid limited currency tailwinds. We expect all companies to maintain their margin guidance. Cost-optimisation remains the key lever for margin expansion, although gains are likely to be partly offset by currency headwinds and continued investments in AI capabilities.

View: Valuation Premium Persists; Re-rating Hinges on Earnings Recovery

Despite the 27% YTD correction of Nifty IT, valuation remains at a premium as compared to global peers, limiting scope for a sustained re-rating until earnings visibility improves. Q2FY27 is likely to remain subdued as elongated decision cycles, phased deal ramp-ups, weak discretionary spending and elevated AI-led pricing pressure continue to delay revenue conversion. While companies are strengthening long-term positioning through AI, engineering and platform-led acquisitions, these investments are yet to translate into a meaningful near-term growth inflection. We anticipate management commentary to remain constructive on the medium-term opportunity but measured on near-term demand. Any rally on the positive commentary is therefore likely to be tactical unless supported by improving discretionary spending, stronger large-deal conversion and AI-services revenue increasingly offsetting productivity-led deflation.

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