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What is the market pricing in?

IT services stocks have been struck down in the last one month, with the Nifty IT Index losing 15% MoM. The narrative that AI is coming for not just IT services but large swathes of the economy could be too strong to shake, at least in the short term. There are no easy answers to whether AI eventually renders IT services obsolete over the long term. For the short to medium term, however, we assess three key questions: 1) What is the structural FCF growth (or the lack of it) being priced in now? 2) What is the extent and timing of AI deflation in the near term, say 2-3 years? and 3) At the risk of thinking linearly, is there evidence of the normal business cycle turning?

The structural FCF growth being priced in

? Our reverse DCF implies that at current prices, the market is discounting an average 10-year free cash flow INR CAGR of ~6.5% (assumptions around WACC and terminal growth outlined in Exhibit 1). This compares to a 40% FCF CAGR in crisis eras such as GFC; a 13% FCF CAGR over FY16-19, when the sector decelerated sharply; and an 8.5% FCF CAGR during FY23-FY26, the latest period of deceleration.

? On an FCF yield basis, large-caps are trading at 5.8% FY27E/6.2% FY28E, levels approaching prior cyclical troughs.

? The core question is whether AI represents a structural break to terminal growth assumptions or merely compresses growth/margins temporarily. If this is a Kodak moment, then the quantum of downside from here is moot. If it is not, the market is currently pricing an FCF CAGR that is among the lowest in the past two decades

Near-term debate: Extent and timing of AI deflation

? As discussed in our prior report (dated 4th Feb’26: Palantir, Anthropic, and its impact on IT services), both the magnitude and timing of AI-induced deflation are key unknowns.

? We have previously estimated that 12-15% of sector revenue faces direct exposure to AI-driven productivity/displacement risk, with incremental pressure from third-party software efficiencies and automation layers. On timing, we estimate two scenarios:

Scenario 1: Front-loaded deflation (12-18 months)

? If deflation materializes rapidly, revenue growth could decelerate sharply across FY27-FY28E, driving EPS cuts of 10% across our large-cap coverage. On these bearish estimates, large-caps would trade at ~18x for both FY27E/FY28E P/E (see exhibits for scenario analysis). This compares to 15-16x 12m fwd P/E at the bottom of the last cycle.

Scenario 2: Gradual deflation, cyclical recovery dominates

? Enterprise complexity, legacy estates, and governance constraints could slow adoption, back-ending productivity gains. In this scenario, near-term growth is more dependent on cyclical recovery, partially offset by AI deflation. ? Is there evidence of this cyclical recovery? Notably, aggregate revenue and EBIT growth bottomed out ~two quarters ago, with meaningful improvement in 3QFY26 across large, mid, and small-cap companies (Exhibit 4-6).

Long-term debate: “IT is dead because this time is different?”

? The concern: AI tools enable enterprises to internally generate code, reducing reliance on third-party vendors and upending pay per seat software.

? Historical context: The IT services industry originally scaled due to the challenges of maintaining large volumes of self-built, non-standardized, and security-vulnerable code. Over time, enterprises shifted toward packaged software + vendor-led customization to address these concerns. As shown in Exhibit 2, self-built software currently accounts for 14% of total software spend, down from 35-40% in the 90s.

? In our view, in-house code generation does not inherently guarantee better architecture, security, or uptime management. Vendor ecosystems continue to play a critical role in:

* Systems integration

* Cybersecurity and governance

* Performance optimization

* Downtime mitigation/SLA management

* In the long term, answers to whether the industry goes extinct, thrives, or just survives won’t come by easily. In the short term, we stick to forecasting earnings growth for the next two years, which, as shown earlier, seems to be improving.

* For the medium term, getting to AI should be a revenue-accretive opportunity, and we believe IT services vendors have a role to play. We keep our estimates unchanged as of now, as we look for more evidence to factor in the current narrative.

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