'Decoupling revenue from IT headcount': UBS on structural evolution, IT outlook

UBS in its latest note on IT sector said the recent sharp selloff in Nifty IT, down 13 per cent in the past two weeks, was triggered by investor concerns over long-term terminal value post the Anthropic and Palantir events, as rapid advances in Agentic Al could structurally weaken the traditional IT services model, which has thus far largely been a staff augmentation model. 

The foreign brokerage said the prevailing valuations suggest that investors are now pricing in terminal free cash flow (FCF) growth of 4-6 per cent compared with 6-7 per cent just a month ago. The valuations suggest FCF yields of 6 per cent, not too far from earlier peaks during the cloud and Covid downturns, thus reflecting a growing scepticism around the sustainability of linear, headcount driven growth. UBS said a structural evolution in business model is key.

“The first and most visible aspect of this evolution is the need to break the historical linkage between revenue growth, and headcount growth. Management commentary across the sector increasingly points to rising non linearity. This is being driven by delivery model changes, automation, and a higher share of fixed price / outcome based work rather than through outright workforce reduction,” UBS said. 

UBS said IT firms such as Persistent Systems Ltd and Coforge Ltd have already demonstrated sharper increases in revenue per employee, with 17-32 per cent increase over the past 3 years, while HCL Technologies Ltd, Tata Consultancy Services Ltd (TCS) and Infosys Ltd have seen the largest increases amongst the large caps (11-15 per cent). 

“Client conversations also suggest rising interest in fixed price and outcome based models, where fees are tied to measurable business results such as cost reduction, cycle time improvement, or revenue uplift. That said, we believe this is still in extremely nascent stages (T&M is still over 50 per cent of revenues in most cases), and we will keep an eye on this likely (and needed) shift,” it said.

UBS said while there has been some near-term overreaction, the questions around terminal growth cannot be ignored. 

While it did not revise its views for now, UBS said it would keep a close eye on how quickly and effectively the IT Services companies adapt to this structural change.

Beyond pricing and delivery models, defending terminal value requires moving up the value chain through a combination of platforms, talent, and ecosystems, UBS said. As per UBS checks, clients are increasingly favouring IT vendors that can bring domain and Al (technical) expertise via platforms / IP, partnerships within the ecosystem, and skilled talent. 

“Vendors have responded by investing in and scaling Al-led platforms and IP, expanding partnerships in the ecosystem, especially with Al and Al- adjacent companies, investing in skilling and niche hiring and enhancing capabilities via focused acquisitions. All of these are key, in our view, for vendors to move from ‘body shopping’ to ‘problem solving’,” it said.