IT service sector: Fast deceleration in figures in Q2 in Finland, better in other Nordic countries

Translation: Original comment published in Finnish on 9/4/2023 at 8:30 am EEST

Uncertainty in customer demand was realized more widely in Q2, but development was even more mixed than before. Companies with a high weight of tailored software development and the private sector suffered more in relative terms. Reported figures included mainly negative surprises, which was also seen in the form of change negotiations and profit warnings. We predict that the duality will continue in 2023, but the demand outlook will remain more subdued as a whole in 2023 in the private sector, while public sector demand is expected to remain at a good level.

Customer demand uncertainty materialized more widely in the sector in Finland in Q2 but the development was mixed

The Q2 result period of the domestic IT services sector was weaker than expected in terms of growth, in a very difficult market environment in some cases. The median organic revenue development of the companies we monitor fell to 0%, from the strong 10% level of Q1. On average, the companies’ organic growth was still 2% (Q1’23: 9%). The weaker development was partly affected by one working day less than in the previous year, while Q1 had one more working day than the previous year. As a whole, the companies fell short of our expectations as 1 was above, 4 in line with and 5 below our estimates. For companies with operations in Sweden and Norway, exchange rates also created headwind. We did not adjust the FX effect from the companies because a majority of the companies did not report it. This had a significant impact especially on Tietoevry (around ~9 percentage points).

The second quarter was even more mixed than the first quarter. Companies with more recurring revenue (longer order books), deep and strategic customer relationships, that operate in the public sector, have long contracts, ERP business, and generally those who make business-critical solutions for customers clearly fared best in Q2. Companies with a high emphasis on the private sector and software development fared the weakest. For the first time, Vincit's and Siili's figures showed the more difficult market situation, as Q1 was still strong for both companies. For Witted, Solteq and Loihde, the weakness was already visible earlier.

Demand in the private sector began to slow down at the end of summer 2022, which was first visible in selective companies and customer sectors (e.g. consumer product sector), but was not much visible in the companies as a whole. In Q2, the changed market situation began to be more strongly reflected especially in tailored software development and as better availability of experts. The competition for customers was tight and, based on the comments of many companies, customer decision-making was very slow in the spring. Price competition was also very tight in some places, as companies sought to move the business at a lower price. This realized in particular in large public sector tendering, but also to some extent in the private sector. For companies operating with longer order books, the weak economic cycle will probably be realized in the figures later, at least in part. By contrast, we believe the public sector is living its own cycle and is more dependent on possible government austerity measures. On the other hand, digitalization brings efficiency to the public sector, and demand related to, e.g.,  social and healthcare services is only beginning to grow. Thus, we estimate that demand in the public sector as a whole will remain at a good level. We believe that the fall in demand that has been rapid in places is only part of normal economic cyclicality. The demand outlook for the sector is still strong in the long term, although we believe that in the short term, it is dependent on an overall improvement in the macroeconomic outlook. In the big picture, it can be said that for the first time in many years, competition has clearly shifted from talent to customers.

In this market situation, projects that are business critical or that can generate cost savings are fashionable, while clearly fewer new development projects are being started. AI has also been a hot topic, and it is particularly interesting in this market situation because it can generate cost savings for the customer and also make the work of suppliers more efficient. However, for the time being, AI still plays a small role. In the coming years it will open up new growth opportunities. However, we suspect that it is difficult for IT service companies in the big picture to stand out from each other competitively.

In a rapidly changing market situation, many companies have had to initiate change negotiations. The change negotiations have concerned both non-billable roles and billable roles. As customer uncertainty persists for longer, it is very likely that new efficiency needs will emerge in the sector.    

After a strong Q1, profitability levels declined in Q2

The median adjusted EBIT margin for the sector was 5.2% in Q2, roughly at last year's level (Q2’22: 5.0%). Last year, company demand was still at a good level throughout the sector, but profitability levels remained relatively low on average. On average, profitability fell to 2.3% from 4.7% last year. As a whole, profitability levels were quite clearly below our expectations as 3 were in line with and 8 below our estimates. Profitability pressure was caused by tighter price competition, especially in the market for tailored software development, wage increases based on collective agreements in the spring, and general inflationary pressure. In addition, one less working day compared to the previous year put pressure on profitability. Overall, we found the profitability level disappointing after a strong Q1 (8.8%). Many companies have responded to the tougher market situation with change negotiations and efficiency measures, which should support profitability levels toward the end of the year if demand stabilizes.

Nordic companies fared better in Q2

We included 10 Nordic listed IT service companies in the review operating in the same service areas as the Finnish companies we monitor. The median growth of other Nordic companies was 14% and organic growth was 7%. Thus, organic growth in the other Nordic countries was relatively much better than for Finnish companies.

The median EBITA-% of Nordic companies (excluding Finnish companies) was 8.2%, which was also better than for Finnish companies (5.2%). Profitability decreased only slightly from 8.5% a year ago.

In 2023, differences between sector companies are more apparent

We estimate that the development of the companies will be divided into different categories in 2023 based on their different profiles. We estimate that the development of companies profiled in tailored software development and operating with a stronger private sector weight will be subdued this year (Siili, Vincit, Witted, Loihde). Solteq is struggling with both a slowdown in demand in the Retail & Commerce sector and product development problems in the Utilities segment, so we expect weak development. By contrast, the development of companies operating in the public sector and in more conventional IT service areas will be steady/good this year (Gofore, Innofactor, Digia, Tietoevry, Netum). For these companies, a clearly higher share of revenue is recurring or based on long-term contracts, which is true also for Digital Workforce. 

Despite the uncertainty surrounding demand, we expect organic growth in the IT service sector to continue as reasonable and M&A transactions to clearly support growth. Strong Q1 figures contribute to growth. We predict that the median revenue growth of the companies we monitor will be 11% and the average will be 12% (estimates after Q1: 13% and 16%). We estimate that the median organic growth, which we monitor carefully, will be 2% and the average 5% (2022: 11% and 14%). Thus, the organic growth estimate increased slightly in Q2 (estimate after Q1: 8% and 9%). We estimate that the median EBITA margin of the companies we monitor will be around last year’s level and be 6.9% (2022: 7.1%). We believe that profitability challenges are caused by lower billable utilization, downward pressure in customer prices, and wage inflation. Tietoevry estimates wage inflation to be around 5% on average. Several companies have already issued profit warnings (Vincit, Siili and Netum) this year, which has often been followed by change negotiations to compensate for decreased customer demand. Loihde lowered its guidance for revenue from digital development. We estimate that a few companies (Loihde and Solteq) will still have to issue a profit warning this year. In addition, if the market situation continues to deteriorate, a few others are still at risk (Witted and Tietoevry). As the competition has shifted from talent to customers, success in sales is critical for growth. Naturally, the companies that have invested in this in the past hold  strong position. On the other hand, the companies whose particular strength has been strong talent recruitment are now benefiting relatively less than before.

However, we think it is relevant for investors to consider what the demand situation will look like in a year and not get too hung up on the short-term outlook. Stock exchanges are likely to sense an improvement in the market situation long before it starts to show in company figures. This has happened in previous crises, and share prices tend to rise quickly from bottom levels. In the sector context, we believe that sales-based valuation levels have already fallen to very moderate levels (2023e EV/Sales: 0.74x) relative to long-term earnings growth outlooks, although crisis pricing is still far away. We think it is now easy to say that, on average, expected returns are more attractive than six months ago, even though there is a lot of uncertainty in the air.

Short company-specific Q2 comments

Digia's Q 2 revenue increased by 16%  year-on-year and exceeded our estimate slightly. Organic growth continued as good (9%). However, the company commented that the growth of tailored software development has slowed down, which is in line with expectations and other comments from the market. EBITA was 7.1% of revenue and increased from a weak comparison period (Q2’22: adj. 5.2%). However, profitability fell from Q1 and was below our expectations (8.5%). Profitability was slowed down by tightened price competition especially in the tailored software development market, the wage settlement negotiated in the spring, and general inflation development. We expect Digia's revenue to grow by 11% in 2023, driven by organic growth. In addition, we expect Digia’s EBITA to increase by 11% and profitability to be at the level of the comparison period (2022: 9.2%), as cost pressure limits the benefits of better billable utilization and investments. Q2 company update on Digia can be found here (in Finnish).

Digital Workforce's H1 revenue grew by 5% to EUR 12.6 million, well below our 20% growth estimate. Thus, we estimate that revenue declined organically by 3%. The strategically important Continuous Services, which account for more than 60% of revenue, grew by only 7% (estimate 29%). The company commented that it had performed very well in growth markets (UK and US), indicating that other markets had fallen, even significantly. Overall, however, we think the low growth was disappointing. EBITDA rose to EUR 0.1 million in H1 and was in line with our estimate (0.2 MEUR). However, the adjusted EBITDA margin fell sharply from 14% in Q4 to 1%. We expect that the company's revenue will grow by 3% and EBITDA will be 2% in 2023. The H1 company update on Digital Workforce is available here.

Gofore's revenue grew by 28% in Q2 to EUR 47.6 million, of which 22% was organic. Although the company commented that the market situation was more difficult in Q2, it was confident in its comments concerning the rest of the year. Gofore’s adjusted EBITA corresponded to a weak adjusted EBITA margin of 11.3% which was good in the sector context (sector 7% in 2022). Customer prices and wage development were in balance. To our understanding, this was partly explained by strong growth in the private sector, where we suspect that the price level is still better than in the public sector. Profitability was depressed by one working day less than in the comparison period and by the fact that billable utilization was under pressure as recruitment intensified and demand weakened. We estimate that Gofore will grow by 30% in 2023, driven by strong organic growth (around 20%). We expect EBITA-% to fall to 13.9% in 2023 (2022: 14.7%), depressed by market conditions. The Q2 company update on Gofore is available here and a comment on July figures here (both in Finnish).  

Innofactor's Q2 revenue increased strongly by 19% supported by the Invenco acquisition to EUR 20.1 million, which was in line with our expectations. Especially positive was organic growth continuing at a good 11% level, despite the headwind from exchange rates (4 percentage points) and the weakening of the market in Q2. Comparable EBITDA accounted for 8.8% of revenue (estimate 9.7%). Supported by the Invenco acquisition, we expect Innofactor's revenue will grow by 12% to EUR 80 million in 2023 (organic 9%) and EBITDA to reach EUR 8.3 million (10.4% of revenue, 2022: 7.8 MEUR). Q2 company update on Innofactor is available here.

Loihde Group's Q2 report met our expectations in terms of revenue (+15.1%), but earnings fell clearly short of our  expectation (adj. EBITA %-2.2%, Inderes: +1.6%). Security solutions continued to develop well, driven by acquisitions and organic growth (estimated +6%), but modest performance continued in digital development (organic decrease estimated at 12–13%) in a very difficult market situation. Profitability was particularly depressed by low billable utilization in digital development, non-recurring ERP challenges in the security business and inflationary pressures. The company’s unchanged guidance is under clear pressure in the very difficult market environment of digital development. We do not believe a small profit warning would be particularly dramatic at the current valuation level if the company succeeds in H2’s strong profitability improvement despite the market situation and challenges in the early part of the year. The Q2 company update on Loihde is available here (in Finnish).

Netum's H1 revenue increased by 11% to EUR 17.1 million and was below our estimate of EUR 18.3 million, but only slightly below the company’s expectations. Organic growth was 6%. Growth was slowed down by delays in some project starts. H1 EBITA was EUR 1.0 million or 5.7% of revenue, which are below our EUR 1.8 million and 9.8% estimates. Earnings driven by revenue and especially profitability was below expected. Profitability was restricted by organic revenue being below expected and continued recruitment, which resulted in continued weak billable utilization. In addition, wage inflation and overall cost increases limited profitability. On Friday, Netum lowered its guidance and now expects revenue to grow by approximately 30% from the previous year and EBITA to be around 7-10% of revenue in the financial year 2023. Our estimates were already within the new guidance. We estimate that revenue will grow by 30% to EUR 37.9 million in 2023. Our estimate expects organic growth to accelerate in H2 to 22% from 6% in H1. In addition, growth in H2 is supported by the Buutti acquisition, by 29 percentage points according to our estimate. We expect EBITA-% to be at the level of the comparison period at close to 9% (H1 6% and H2e 11%). Thus, achieving our estimates already requires strong performance from the company in H2. H1 company update on Netum can be found here (in Finnish).

Siili's Q2 revenue increased by 7% to EUR 31.6 MEUR, and was in line with our estimate. Organic growth was 3 percentage points. The company issued a profit warning in July and, thus, the weakness was already known. The rapid change in the market situation and operating environment in Finland and internationally slowed down some new project starts. EBITA was weak at 5.2% of revenue (Q2’22: 10.0%). Profitability weakened due to slowed revenue growth, wage inflation, price competition, and growth in ICT costs. In August, the company started change negotiations to improve profitability. In addition, the company seeks new efficiency measures. We expect the company to grow by 6% to EUR 126 million and EBITA to be EUR 8.6 million. The Q2 company update on Siili is available here (in Finnish).

Solteq's Q2 revenue decreased by 20% to EUR 14.3 million, which was below our estimate of EUR 15.6 million. Organically, revenue decreased by 8% driven by both segments. Comparable EBIT was EUR -1.9 million or -13% of revenue and well below our estimate of EUR -0.1 million and -1%. The sales gain from sold retail ERP systems improved the reported result by EUR 8.3 million.  Solteq announced that it will initiate change negotiations to improve the profitability of the Utilities segment and to restructure its business. The company aims to achieve annual cost savings of EUR 3 million from Q4’23 onwards. We expect that it is highly likely that the company will have to issue a profit warning (2023e EBIT adjusted for sales gain: -2.4 MEUR or -4% of revenue). Q2 company update on Solteq is available here (in Finnish).

Tietoevry's revenue fell by 6% in Q2 to EUR 695 million and was below our and market expectations. Organic growth slowed to 3% (Q1: 8%). Exchange rates had a large negative impact of 60 MEUR. In Q2, EBITA-% was 10.5%, and below our and market estimates. Profitability was still limited by, e.g., high inflation. The company commented that H2 is seasonally strong, supported by the order backlog and efficiency measures. We expect the company’s revenue to decrease by 2% (organically +5.4%) and the EBITA margin to be 13.2% in 2023. Q2 company update on Tietoevry is available here. 

Vincit's revenue increased by 36% to EUR 25.0 million in Q2 and was in line with our estimate. Organically, we estimate that revenue decreased by ~7%, reflecting the sudden slowdown of the market, while in Q1 it increased by +14%. The weak development was caused by a more difficult market environment than expected and tighter competition, especially in tailored software development. EBITA was EUR -0.4 million or -2% of revenue in Q2 and in line with our expectations. Profitability was depressed by a general increase in cost levels, collective agreement-related wage increases that took effect in April, and especially the EUR 0.5 million (2% of revenue) one-off payment fully recorded in Q2, adjusted for which the result was actually a bit above expectations. We expect Vincit to grow by 16% (organically -2%) to EUR 99 million in 2023, driven by the merger. We also expect EBITA-% to fall to 4.1% in 2023, depressed by higher cost levels and billable utilization (2022: 6.1%). Q1 company update on Voncit can be found here (in Finnish).

Witted's revenue grew slightly slower than we expected (+25%, Inderes: + 28%), fully supported by the Nexec acquisition. Organically, revenue decreased by 4% in a difficult market situation and partly driven by FX (impact on revenue estimated to be -3 percentage points). Profitability fell to a weak level (EBITA-% -3%), depressed by billable utilization and costs of organizational changes, and was also slightly below our expectations. The company still expects to turn profitability clearly positive toward the end of the year with several long-term cost savings measures and did not change its guidance. Witted continues to take steps to adapt to the tight market situation, but we believe the visibility of the market improving remains low. We suspect uncertainty about the success of the company’s ongoing transformation remains high, especially before information on business development during the rest of the year. We expect the company will barely reach a positive EBITA result, so the company is also a potential profit warner if the market weakens further. The Q2 company update on Witted can be found here (in Finnish).