Jefferies has issued a cautionary note about the IT sector, warning that the AI revolution is far from over. The brokerage firm predicts that artificial intelligence will significantly impact business models, potentially causing structural changes and putting pressure on valuations. Despite the recent rebound in IT stocks, Jefferies remains cautious, citing a less favorable risk-reward equation. They have adjusted their earnings per share estimates downward by 1-4% and lowered price targets by up to 33%.
Among the companies affected, Infosys, HCLTech, and Mphasis have been downgraded to 'Hold', while TCS, LTIMindtree, and Hexaware are now classified as 'Underperform'. Wipro continues to be rated 'Underperform'. Coforge, Sagility, and IKS Health are highlighted as preferred picks. Jefferies' note, titled 'P(AI)n Not Over Yet; Stay Selective', emphasizes that AI is expected to shift revenue streams towards consulting and implementation services, while reducing the dominance of traditional managed services.
This shift could lead to increased revenue volatility and necessitate significant changes in talent and operating models, posing execution risks for IT companies. While third-quarter results initially boosted earnings for most IT firms, investor focus has now shifted to the medium- and long-term impact of AI. The Nifty IT index has declined by approximately 14%, underperforming the Nifty 50, which reflects concerns that AI-driven efficiency gains might result in pricing pressure for core services.
Jefferies predicts that application managed services, which contribute around 22-45% of revenues for large IT firms, could face deflation as AI tools become more advanced. Although a higher proportion of advisory and implementation work may support growth, it could also necessitate adjustments in delivery models and cost structures. The brokerage estimates that current stock prices imply revenue growth of 6-14% for large IT firms and 9-17% for mid-sized players over the next few years. Despite these growth projections, Jefferies believes there is still room for further valuation compression.
In its base case, Jefferies anticipates limited upside in price-to-earnings multiples for large IT firms, while mid-sized companies could see better rerating potential. However, in a downside scenario, stocks could face further derating of 30-65% if revenue growth slows sharply. Overall, Jefferies expects sector earnings CAGR of around 6% during the next few years, with Coforge, Sagility, and IKS Health likely to outperform with growth of 19-25%. The brokerage firm favors mid-sized IT firms, citing their greater agility in adapting to AI-led changes.
