A new paradigm: IT companies will need to adjust business models

The 3QFY25 (October-December 2024) results and associated management guidance from the information-technology (IT) sector indicate that the industry may be on the cusp of a tectonic shift in business models. This impression was reinforced by industry leaders at the recent Nasscom Technology and Leadership Forum. While the third-quarter results were decent and guidance was cautiously upbeat, the impact of the adoption of artificial intelligence (AI) is clearly being felt and this will necessitate a change in business models for the classic Indian IT services firm. Management commentaries reflect an improving macro environment with green shoots in discretionary spending, while the deal pipeline is strong. As generative AI adoption increases, output is no longer directly correlated to headcount and business clients are looking at moving to the hyperscaler model, with an increase of “insourcing”. HCL Tech Chief Executive Officer and Managing Director C Vijayakumar says clients are now looking to double revenue while deploying half the headcount.

 

While the Indian IT industry says AI will create more jobs than it extinguishes, there could be short-term pain and entirely new business models will be required in the long term. As of now, Nasscom estimates around 400,000 IT industry workers are AI-skilled, though less than 100,000 are highly skilled. The AI-competent number could climb to around 1.7 million in the medium term and about 2.7 million in the long term. But in the short term, headcounts could freeze or fall. According to Gartner, IT spending is expected to grow robustly at 10 per cent in 2025. Spending on AI-optimised servers is projected to double in 2025, reaching $202 billion, with IT services companies and hyperscalers accounting for 70 per cent or more of this spending. Hyperscalers are pivoting to the AI model market, and projections include operating $1 trillion worth of AI-optimised servers by 2028.

 

Hyperscalers are guiding towards a pickup in generative AI integration, which will lead to workload shifting from on-premise to cloud, data services, infrastructure services, and cybersecurity. Insourcing will become a more attractive option for clients. Distinctions between IT services, data centres, and hyperscalers are blurring because the business models and skill sets of all three sectors converge. AI will generate significant productivity benefits in services and also provide new opportunities but there is a near-term risk of AI adoption leading to downsides in revenue growth, operating margins, and valuations. Areas like software development, testing, and horizontal business process outsourcing (BPO) are becoming increasingly AI-driven and many clients are initiating data infrastructure modernisation and legacy code updating. The increase in AI capabilities and a reduction in costs will boost AI adoption, driving new opportunities for Indian IT service providers.

 

Most IT services companies view revenue-deflation risks as manageable since they can cut costs through internal AI adoption and eventually new revenue streams will arise from the adoption of generative AI. The use of AI at scale to eventually transform business operations will be a large future opportunity. But in the short term, generative AI adoption could lead to a 2-3 per cent negative impact on revenue growth over a period of two-three years until AI adoption creates enough new use cases for demand to turn positive. Areas like application development and business process outsourcing could see a higher revenue-deflation impact. Mid-tier Indian IT firms have a higher exposure to application development than Tier-I companies. However, every Indian IT firm will have to review the decades-old business models.