New Delhi [India], April 29 (ANI): The Indian IT services sector faces a prolonged phase of slower growth and margin pressure as AI-driven budget shifts crowd out traditional services spending, with no meaningful recovery in sight for FY2027, according to a brokerage report. While total technology spending is accelerating, the incremental dollar is flowing into GPU infrastructure, foundation models and AI software rather than services, compressing the pie for Indian vendors.

The brokerage noted that AI deflation is becoming a reality, with the industry's base case set at 3.5 per cent pricing erosion, first surfacing through renewals of large multi-year contracts rather than initial GenAI pilots. 'Clients working with AI in production demand efficiency gains be passed through to pricing on existing contracts,' the report said, adding that this renewal-driven deflation is 'unambiguously negative for margins and revenues' when headcount intensity remains unchanged.

The march quarter earnings results of IT companies reinforced what was already known but compressed the timeline for when the thesis bites. The brokerage said revenue misses were broader and deeper than Street estimates, with every Tier-1 player except TCS falling short. HCLT became the first to quantify AI deflation at 3-5 per cent for the industry. The market had been pricing a marginal recovery in FY2027, but the results confirm there is no recovery in sight.

A key shift is the end of the share-gain era that cushioned performance for strong players over the past decade. 'The dispersion in growth among Tier-1 companies may reduce in FY2027E (except Wipro),' the report said, noting that guidance bands and consensus estimates are now tightly clustered at 1 to 4 per cent across Tier-1s. TCS has returned to mega-deals with a $12 billion TCV, while TechM has executed its turnaround and is winning large telecom contracts. 'Every player now bids for the same deals, in the same markets, at the same productivity benchmarks,' the report added. With the total deal market not expanding to accommodate all, the fight is over a services pie that is growing in nominal terms but shrinking in AI-adjusted pricing terms.

The mechanism of deflation matters for margins. AI reducing delivery cost with proportionate headcount reduction is margin neutral, while price cuts on unchanged scope are dilutive. A third scenario, expanded scope at the same price, is margin dilutive but sustains revenue. What remains unclear is the mix of renewals, though rupee depreciation has masked the transmission so far, the brokerage noted.

On the positive side the brokerage noted that GenAI deflation is cyclical, not secular, with the 2-3-year phase giving way to new billable work in data architecture, agentic workflows and AI governance. Mid-tier firms are better positioned to capture this, with PSYS leading. Verticals such as financial services and energy and utilities remain healthy, and mega-deals continue to flow. Valuations are not demanding, with Tier-1 prices embedding only 3-4 per cent USD revenue CAGR to perpetuity at stable marginsa valuation floor rather than a re-rating catalyst.

The report said structural challenge lies in budget allocation. Total tech spending grew 10.9 per cent in 2025 and is expected to accelerate to 13.4 per cent in 2026, per Gartner, while IT services grew just 3.1 per cent in 2025 and is forecast at 4.2 per cent in 2026. 'Enterprise technology budgets are not expanding fast enough to accommodate both AI infrastructure and services spending,' the report said, noting that POC budgets and now production-driven renewals are crowding out services contracts.

The long-term debate hinges on whether spending on services grows at all. The 10-year average for global IT services is 5 per cent in constant currency, but it has slowed to 3 per cent in CY2025 and is likely to remain range-bound through CY2026. The brokerage argues that an outright decline is premature, as complexity from agentic AI adoption will sustain demand for integration and operational work. 'At 3 per cent growth, the IT services sector remains investable,' it said. 'The challenge is not growth disappearing, but the absolute pool growing slowly while competitive intensity remains high.' (ANI)