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2025 Outlook: Role reversal and mean-reversion

CY25-start has little in common with CY24’s. Last year this time, book of business was transitioning from (eroding) discretionary book to efficiency-led work. Leakages have reduced since then and mega deals’ contribution is now in the base. In fact, players need short duration discretionary deals to pick-up now to make up for declining TCV. Fed’s dovish turn in Dec-23 raised hopes of faster rate-cuts, triggering re-rating in IT Services stocks then. Opposite happened in Dec-24 – hawkish tone, elongated rate-cut projections and a sell-off. In other words, better demand environment is balanced by somewhat unfavourable comp and higher expectations. This different set-up means construct of stock return could be different too. CY24 stock performance was led by (2)%-19% re-rating across large-caps even as FY25/26E EPS saw 1-20% cut. +1SD PER now means stock performance in CY25 should track earning upgrades. That would largely be margin-led. On multiples, we might see some mean-reversion – TCS’ premium over large-caps and Auto ER&D’s over mid-caps.

*Discretionary spend in CY25 - good but not great: S&P 500 earnings growth is likely to improve to c.15% in CY25 (Source: Factset). Unlike CY24, where bulk of earnings growth is being led by Magnificent 7, it will also be broad based. That suggests cost pressures might ease across enterprises, paving the way for discretionary spend off-take. That said, a still gummed up global supply-chain, uncertainty around Trump’s trade policies and a sudden shift in Fed’s tonality mean long gestation (back-ended ROIs) projects may get pushed out. Our checks also suggest that IT budgets are unlikely to improve materially.

*Lower corporate taxes to have marginal impact: One reason for optimism on IT Services demand post Trump’s election is potentially lower corporate taxes (18% from 21% for domestic production). Our analysis suggests that its impact, though positive, would be marginal. Effective tax rate - calculated simply as (PBT-PAT)/PBT - for S&P 500 has fallen by 0-11ppt across sectors over 2016-23 (Exhibit 3). Two verticals where ETR is still above 20% - Consumer Staples and Energy - growth expectations are the least (Exhibit 4). Business outlook, and not fiscal support, will determine IT Services demand, in our view.

*US Telecom – a wild card?: Communication Services (CS) has been one of the worst hit verticals for IT Services providers recently. That could change in CY25. CS’ finances seem to be on the mend. CS companies in S&P 500 saw the most earning surprises in Q3. As a result, CS sector witnessed the highest earnings upgrades over the past six months (Exhibit 8) within S&P500. Our excess IT spend analysis also suggests post-COVID excess spend in Telecom has likely flushed out now (Exhibit 10), resetting the base. These typically precede inflection in IT Services spend. If they do, TECHM could benefit more.

*Keep an eye on TCS: Top-5 large cap IT Services stocks gave 7-32% return in CY24. A break-down of this performance (Exhibit 11) reveals that barring TCS, every other stock saw PER expansion. Surprisingly, consensus’ earning downgrade for TCS (for FY25/FY26E) through CY24 was one of the least. Consequently, TCS’ premium to large-cap peers is now at decadal low. This, we believe, indicates that investors are positioned for demand recovery. BSNL ramp-down and recent disappointment in core growth mean TCS’ growth could lag peers in FY26. CMP is already discounting these risks, in our view. Sustained improvement in US BFSI and delay in broad-based discretionary spend could play in TCS’ favour.

*Stock performance - Role-reversal and mean-reversion: Unlike CY24’s PER re-rating led return (Exhibit 11), CY25’s performance should track earnings upgrade, in our view. Street’s current estimates for FY26E USD revenue growth is 5-11% across top-6 (Source: Visible Alpha), implying 1.9-3.1% CQGR (ex-HCL). A softer 2H - assuming normal seasonality – would raise 1HFY26 ask rate further to 2.2-3.4%. We see limited upside to these estimates. We however don’t rule out margin expansion-led earnings surprises. INFO/COFORGE could see earning upgrades while LTIM could see potential cuts. TECHM should continue to benefit from roll-forward. On multiples, expect some mean-reversion: TCS’ premium to large-caps (not built in our TP currently) and Auto ER&D players’ PER premium to mid-cap IT basket

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