Is AI emerging as a double-edged sword for the IT sector? While companies are seeing rapid growth in AI-related business, it is also creating deflationary pressure in traditional IT services by reducing development volumes and increasing pricing pressure. As a result, Kotak Institutional Equities expects the sector to face another challenging year.
“IT companies will face headwinds from another year of moderate growth, pricing pressure in the base business, AI-related investments and transition costs in deal ramp-ups,” Kotak added.
AI begins to weigh on traditional IT services
Kotak Institutional Equities elaborated that AI adoption is beginning to reduce revenue from conventional IT services.
As companies use generative AI to automate software development and improve efficiency, clients require fewer billable hours in time-and-material contracts. At the same time, pricing pressure has increased in fixed-price managed services deals.
“The headwinds are manifesting as lower volumes/spending in software development programs and higher pricing pressure in managed services deals. These impact topline growth for the industry,” Kotak noted.
The impact is being felt more by large Tier-1 IT firms such as Infosys, TCS, Wipro and HCLTech, which have a larger base business. In contrast, mid-tier companies such as Persistent Systems, Hexaware and Coforge have managed to offset these pressures through market share gains and new deal wins.
AI business growing fast, but not enough
Growth in AI business is still not large enough to offset the deflationary impact on companies’ core services business, Kotak highlighted.
The strong growth in AI-related business shows that companies are moving AI projects from the testing stage to real-world deployment. It also indicates that Indian IT firms are playing a bigger role in providing AI services, the brokerage house added.
While these are positive signs for the sector, “effect of deflation in the base business will more than offset tailwinds from new AI use cases in the near to-medium term,” said Kotak.
TCS reported AI-related revenue of $2.6 billion (annualised), which grew 13.6% quarter-on-quarter (QoQ) in US dollar terms. HCLTech reported advanced AI revenue of $688 million (annualised), which grew 10.6% QoQ, while Infosys’ AI revenue contributes 8.2% to its overall revenue and has grown rapidly over the past few quarters.
AI gains, weak demand weigh on IT sector growth
The IT sector is also facing the pressure of incumbency, meaning the pressure to pass on productivity benefits from AI gains. Weak client spending and limited scope for expansion in mature accounts are also weighing on growth for IT sector.
Along with AI, the impact of geopolitical tension is expected to continue in Q2FY27. However, “We believe macro uncertainty has reduced, which will help drive away deal delays,” Kotak noted.
Margins remain resilient despite weak growth
IT companies still managed to protect their margins and profitability in Q1FY27 despite sluggish revenue growth, slower deal ramp-ups, cautious client spending and AI-led productivity gains by implementing tighter cost controls, including layoffs, delayed wage hikes and lower variable pay.
“Incremental margin pressure is being absorbed by further rupee depreciation and aggressive cost control,” Kotak noted.
Conclusion
Kotak expects Tier-1 IT companies to report sequential revenue growth of around 0-2% in the September quarter as demand remains weak, although easing macro uncertainty could reduce deal delays.
The brokerage expects Persistent Systems to lead growth among mid-tier firms, driven by the ramp-up of a large hi-tech deal.