AI threat to Indian IT stocks? Motilal Oswal explains road head for sector

The sharp 15 per cent month-on-month decline in the Nifty IT Index has rekindled a familiar debate on Dalal Street: Is this downturn cyclical, or does artificial intelligence (AI) represent a structural disruption for India’s IT services industry?

 

In a recent note titled “Indian IT services: Assessing the narrative shock”, analysts Abhishek Pathak, Keval Bhagat, and Tushar Dhonde of Motilal Oswal Financial Services (MOFSL) attempt to decode what the market is pricing in and whether fears of an existential AI threat are overdone.

What is the market pricing in?

According to MOFSL’s reverse discounted cash flow (DCF) analysis, current stock prices imply an average 10-year free cash flow (FCF) CAGR of around 6.5 per cent for the sector.

 

 

“Our reverse DCF implies that at current prices, the market is discounting an average 10-year free cash flow INR CAGR of 6.5 per cent,” said MOFSL.

 

This is materially lower than historical precedents. During crisis periods such as the Global Financial Crisis (GFC), FCF CAGR stood at 40 per cent. In FY16–19, when growth decelerated sharply, the sector clocked a 13 per cent FCF CAGR. More recently, during FY23–FY26, another phase of deceleration, FCF CAGR was 8.5 per cent.

 

On valuation metrics, large-cap IT companies, according to the analysts, are trading at FCF yields of 5.8 per cent for FY27E and 6.2 per cent for FY28E. These levels are approaching prior cyclical troughs.

 

The brokerage frames the key question as whether AI represents a structural break to terminal growth assumptions or merely compresses growth and margins temporarily. If this is a Kodak moment, then analysts believe the quantum of downside from here is moot. “If it is not, the market is currently pricing an FCF CAGR that is among the lowest in the past two decades,” said the analysts.  CHECK Stock Market LIVE Updates

The near-term debate: Extent and timing of AI deflation

MOFSL estimates that 12 to 15 per cent of sector revenue faces direct exposure to AI-driven productivity and displacement risks. There could be incremental pressure from third-party software efficiencies and automation layers.

 

However, the timing and magnitude of AI-induced deflation, analysts said, remain uncertain.

The brokerage outlines two scenarios:

Scenario 1: Front-loaded deflation (12 to 18 months)

If AI-led deflation materialises quickly, analysts believe revenue growth could decelerate sharply across FY27 and FY28. In such a case, earnings per share for large-caps could see cuts of around 10 per cent. Under these bearish estimates, large-cap IT stocks would trade at roughly 18 times FY27E and FY28E earnings, compared to 15 to 16 times 12-month forward P/E at the bottom of the last cycle.

Scenario 2: Gradual deflation, cyclical recovery dominates

According to MOFSL, enterprise complexity, legacy systems and governance constraints could slow AI adoption, pushing productivity gains further out. “In this scenario, near-term growth is more dependent on cyclical recovery, partially offset by AI deflation,” said the analysts.

 

On whether there is evidence of cyclical recovery, MOFSL pointed out that aggregate revenue and EBIT growth appear to have bottomed out around two quarters ago, with meaningful improvement seen in Q3FY26 across large, mid and small-cap companies.

The long-term question: Is IT structurally threatened?

A core concern, according to MOFSL, is that AI tools could enable enterprises to generate code internally, reducing reliance on third-party IT vendors and potentially upending the traditional pay-per-seat software model.

 

MOFSL offers historical context. The IT services industry originally scaled because enterprises struggled to maintain large volumes of self-built, non-standardised and security-vulnerable code. Over time, companies shifted toward packaged software combined with vendor-led customisation. At present, self-built software accounts for 14 per cent of total software spend, down from 35 to 40 per cent in the 1990s.

 

“In our view, in-house code generation does not inherently guarantee better architecture, security, or uptime management,” said the brokerage.

 

The analysts said vendor ecosystems continue to play a critical role in systems integration, cybersecurity and governance, performance optimisation, and downtime mitigation and service-level agreement management.

Estimates unchanged for now

While acknowledging that long-term outcomes, whether the industry goes extinct, thrives or just survives, will not come easily, MOFSL said its focus remains on forecasting earnings growth over the next two years, which appears to be improving.

 

“In the long term, answers to whether the industry goes extinct, thrives, or just survives won’t come by easily,” said the brokerage.

 

For the medium term, the brokerage believes AI adoption could turn revenue-accretive for IT services vendors.

 

For now, MOFSL has kept its estimates unchanged as it looks for more evidence before factoring the current narrative into its numbers.      =============================================== 

(Disclaimer: The views and investment tips expressed by the analysts in this article are their own and not those of the website or its management. Business Standard advises users to check with certified experts before taking any investment decisions.)