Indian IT: Macro weakness and GenAI disruption

The IT Services sector has seen notable weakness YTD, with Nifty IT underperforming the broader Nifty index. Against this backdrop, we assume coverage and address two key questions: 1) What is the potential impact of GenAI developments? and 2) Are macroeconomic uncertainties improving? While GenAI’s influence is beginning to emerge, we believe significant disruption is a few years away. Near term, macro and geopolitical challenges remain the primary focus; that said, there are initial signs of stabilisation. Our outlook for large caps is cautious. In contrast, we hold a more constructive view on mid caps.

UBS Evidence Lab survey results, channel checks, and other analyses indicate that most enterprises are starting to explore use cases for GenAI, but adoption remains in the early stages. Currently, only a small number of enterprises have reached the production phase, and large-scale implementation is likely a few years away. However, we believe investors should begin positioning now for an upcoming cycle. Based on detailed analysis of various factors, we introduce our new GenAI Disruption Framework, where we try to assess the potential impact on IT services companies. The framework suggests that mid-cap companies are better positioned to withstand disruption from this cycle,. In contrast, large-cap companies may experience more disruption. Given the rapid advancements in this area, we plan to periodically reassess the 'GenAI readiness' of companies using this framework.

Macroeconomic outlook remains uncertain amid geopolitical and trade policy challenges, but evidence points to some signs of stabilization. Stabilizing probability of US recession (c52% as per UBS model), consumer confidence (97 in August, vs 86 in April, although still below 2024 levels) as well as corporate revenue growth after a period of deceleration, coupled with likely rate cuts (c100bps by December as per UBSe), all give us some incremental comfort. These factors collectively indicate stabilising (if not improving) sentiment for IT services companies. That said, any further deterioration (including potential new taxes on outsourced servicesor new tariffs) would pose downside risks to our (and street) forecasts.

Large caps have had a soft couple of years (avg. FY23-25 revenue CAGR of 1%). While we expect some recovery (FY25-28E CAGR of c5%), we believe they have more to lose in the GenAI cycle. We therefore believe PE multiples at or below their 3-year averages are fair. On the other hand, mid caps have performed better in recent years (FY23-25 revenue CAGR of 10-20%, aided by market share gains and focussed execution), and look better positioned for a GenAI cycle. Therefore, in our view, a premium to their 3-year averages is fair.