Jefferies has issued a cautionary note, warning that the AI-driven IT sector is not out of the woods yet. Despite the recent rebound in IT stock prices, the brokerage firm is urging investors to remain vigilant. The key concern? Artificial intelligence could disrupt traditional business models, impacting valuations and earnings. While IT stocks have shown a 16% year-to-date increase, Jefferies believes the risk-reward ratio is still unfavorable. As a result, they've adjusted their earnings per share estimates downward by 1-4% and reduced price targets by up to 33%.
The brokerage firm has downgraded several IT stocks, including Infosys, HCLTech, and Mphasis, to 'Hold' status. Meanwhile, TCS, LTIMindtree, and Hexaware have been moved to 'Underperform'. Wipro remains in the 'Underperform' category, while Coforge, Sagility, and IKS Health are their preferred picks. Jefferies attributes this to AI's potential to shift revenue streams towards consulting and implementation work, reducing the dominance of traditional managed services. This shift could lead to increased revenue volatility and necessitate significant changes in talent and operational models, posing execution risks for IT companies.
Jefferies highlights that 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, reflecting concerns that AI-driven efficiency gains could exert pricing pressure on core services. The brokerage firm predicts that application managed services, which contribute around 22-45% of revenues for large IT firms, may face deflation as AI tools improve.
While a higher share of advisory and implementation work could support growth, it may also necessitate changes in delivery models and cost structures. Jefferies 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 decade. Although these assumptions are below historical averages for several companies, the brokerage firm 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 FY26-28, 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.
