Kotak Institutional Equities has reaffirmed its top IT stock picks as Infosys, Tech Mahindra (TechM), Coforge, and Hexaware. The announcement comes amidst a challenging environment in the IT sector, characterised by weak demand, margin pressures, and aggressive cost-cutting measures.
Despite strong deal total contract values (TCVs) across companies, margins are under pressure due to deferred wages and cost optimisation strategies. Kotak notes that stock prices have corrected, making valuations less demanding, with free cash flow (FCF) yields over 4.5% and payout yields around 4%.
Kotak states that tier 1 and mid-tier IT firms are trading at a one-year forward price-to-earnings (PE) multiple, aligned with their respective historical averages. This has made Tier 1 valuations attractive due to appealing FCF and dividend yields. Mid-tier firms like Coforge and Hexaware trade at premium valuations, justified by growth potential, Kotak said.
The brokerage reports a weak revenue performance in Q1 for the IT sector, with four of the five large IT companies showing a quarter-on-quarter revenue decline. While the BFSI vertical saw growth, manufacturing, retail, and healthcare underperformed. Kotak attributes weak demand to tariff impacts and reduced discretionary spending.
Kotak highlights that “a few margin levers are exhausted-such as utilisation and subcontractor usage. Pyramid and pricing are difficult to leverage in a tough demand environment. Companies are leaning more on direct employee costs as a result, leading to lower variable payouts, wage hike deferrals, stricter performance management and layoffs/restructuring.”
The firm also observes that the IT sector is at an inflection point, with valuations not expensive but dependent on a revival in discretionary spending for profitability. Kotak reiterates its preference for Infosys, TechM, Coforge, and Hexaware as the sector seeks demand tailwinds.
Kotak notes that “we believe the use of AI agents is still in an exploration stage. Issues around accuracy, reliability, hallucinations, and security need to be ironed out before companies can confidently scale up adoption of AI agents. The services opportunity in AI agents will also be a key point of debate when such ecosystems mature.”
Furthermore, Kotak states, “we believe ramp-up of existing GCCs has slowed down while momentum in new GCC set-ups continues. Despite the slowdown in hiring in mature GCCs, there continue to be a few sparks, indicating a possible shift to more insourcing in select firms. Media reports indicated increasing insourcing plans for Citi in March 2025 although there has not been an update till then. Recently, HSBC was actively hiring for leadership roles related to insourcing with a focus to scale up hiring in technology centers in multiple such locations around the world.”
Additionally, the IT sector is facing challenges from other tech investments. Hyperscalers and software vendors are increasingly capturing enterprise IT budgets through subscription models and as-a-service offerings. Generative AI is also becoming a focal point, with companies exploring its potential despite current limitations. This shift could impact traditional IT services, as AI-driven productivity gains are prioritized.