Q2 IT service sector summary: Slightly steeper revenue decline, improved profitability and signs of demand bottoming out

Finnish listed IT services companies' organic revenue decline accelerated slightly, although the comparison period was already weak for several of them. However, profitability improved year-on-year, supported by cost savings, albeit slightly below our expectations. Overall, the trends in Q2 were similar to previous quarters. Our main concern remains the fierce price competition, which seems to have spread to the majority of players in the sector and is eating deeper into companies' order books. This means that the recovery will also be slower than we had previously expected. In the short term, we expect competition to remain intense, but we believe that the expected strengthening of the general economic development in Finland and Europe and the likely further decline in interest rates will create the necessary conditions for a gradual improvement in the demand outlook next year.  The quarter-on-quarter decline in the number of employees slowed in Q2 compared with previous quarters, giving some confidence that the bottom of demand is near.

Organic revenue development continued to weaken in Q2 on a working-day adjusted basis

In Q2, revenues in the Finnish IT services sector developed slightly better than we expected in a still difficult market environment. The comparison period was somewhat easier than in Q1, as the market weakness had already impacted figures across the board a year ago. Revenue of the companies in our coverage declined organically by 1%, a slight easing from Q1 (-2%). On the other hand, one working day more than in the previous year (an impact of just under 2% per quarter) supported this development. Thus, adjusted for working days, the organic development continued to deteriorate from the previous quarter (Q2: -3% vs. Q1: 0%). Overall, however, revenues were slightly better than expected in Q2, with 3 companies above, 7 in line with and 1 below our forecast. In the coming quarters, the comparison periods will become more favorable, as from Q2'23 onwards a clear slowdown in demand started to be reflected in the revenues of many companies. In addition, there is also one working day more in Q3 than in the comparison period, which supports revenue and especially profitability.

 

Source: Inderes

In the big picture, the trends in Q2 were the same as in previous quarters. As the market situation became more challenging last year, the companies with more recurring revenue, long-term contracts, deep and strategic customer relationships, those operating in the public sector, and generally those who make business-critical solutions for customers have fared well. Companies with a high emphasis on the private sector and customized software development fared the weakest. The weakness of customized software development at Vincit, Siili Solutions, and Witted, among others, was clearly reflected in the development of the companies' revenue. However, the differences between the companies have narrowed slightly, as even the stronger growth companies in the sector are not immune to market changes (Gofore). Digital Workforce was the exception, with organic growth strengthening significantly to 14%. The most apparent reason for the narrowing of the gap was the slight easing of Vincit's and Witted's decline. There has been, and still seems to be, a trend in the market that buyers at large customers are concentrating their purchases on a narrower range of suppliers. If this trend gains momentum, we see it supporting operators with a comprehensive lifecycle service offering. We also expect companies with clear competitive advantages to stand out more prominently in the future. The losers will be companies that lack critical (data, AI) or differentiating capabilities, deep customer relationships (contributing factors being management consulting, integration and continuity services), or a deep understanding of the customer's business through industry focus.

 

Source: Inderes

Price competition remains fierce and could be said to have expanded in recent quarters as several listed companies have also entered the fray. This is our main concern for the sector. An example of price pressure is Gofore, whose average customer prices fell by 1.0% in Q2'24 from +3.8% in Q1'23. Before the significant increase in price competition, Gofore's customer prices were still rising by 3.5% in 2022 and 2023. However, the majority of Gofore's business is in the public sector on long-term contracts, which even slightly masks the true picture of price pressure as it has not yet fully penetrated the order book. Price competition is putting pressure on profitability in the IT services sector while wages do not show a similar elasticity (Gofore +0.1% Q2'24). We do not see an end to price competition until demand picks up, which we believe will require a strengthening of the economic environment, which would in turn increase the investment appetite of customer companies.

The quarter-on-quarter decline in the number of employees slowed (to -1%) in Q2 compared to previous quarters (Q4’23: -4% and Q1’24: -2%). This gives some confidence that the bottom of demand is near.

Source: Inderes

Total number of employees as reported by the companies. Gofore, Siili, Vincit and Witted calculated on the basis of the FTE reported by the companies. The number of employees at Loihde in Q1 is estimated based on the average of Q4 and Q2. 

Interest rates (long-term rates and Euribor) have turned downward, driven by slowing inflation, but also partly by a more delayed recovery in the economic outlook for the eurozone. Interest rates are expected to fall further, with Euribor futures predicting that the 3-month Euribor will decline to around 2.3% next year from the current level of around 3.5%. As the European economy improves next year, we see prospects for stronger demand over the next year. The need for digital investment remains as strong as ever, and companies have also put development projects on hold due to cost-cutting measures. In the short term, we believe that the development of demand in the sector will depend on the general economic situation and forecasting the industry will remain more challenging than usual.

Cost savings did not support profitability as much as expected in Q2

The sector's average adjusted EBIT margin was 5.1% in Q2 (median 3.5%), down from the previous quarter (6.4%) but up slightly from the comparison period (2.1%). In the comparison period, weakening demand caught several companies in the sector by surprise, and the comparison period is the weakest quarter in our monitoring history. The median profitability was much lower than the average. We think it is more useful to look at the average in the current situation, because in a small sample the median can fluctuate wildly depending on which company happens to be in the middle of the sample group. The improvement in profitability was well expected, but the magnitude was below our expectations. Thus, as a whole, profitability levels were slightly weaker than we expected, with 1 company above, 4 in line (within 1 percentage point), and 6 below our forecast. Profitability was supported by the cost savings the companies made last year. In addition, one more working day compared to the previous year supported profitability. However, profitability came under pressure from a stronger-than-expected decline in customer demand and, in particular, from fierce price competition, while wages do not have a similar elasticity. If the weakness in demand spreads to new areas of expertise and/or customer sectors, new change negotiations are likely. If the decline and/or weakness persists, the company will also be under pressure to adjust its more fixed cost items. On the other hand, companies that make it through a difficult cycle without change negotiations will, in our view, strengthen their employer brand.

 

Source: Inderes

The sector's profitability is now (5-6%) clearly below past levels (4y 8.2% and 6y 7.5%). Now that companies have sharpened their cost structures after years of strong investment, as the economy and demand recover, we may see profitability return to much better levels, at least temporarily. We will publish our updated expectations for the IT services sector in 2024 in the near future.

 

Source: Inderes

Short company-specific Q2 comments

Digia's Q2 revenue increased by 9% over the comparison period to 52 MEUR, slightly above our expectations. Organic growth strengthened slightly from previous quarters to 3%, a good level considering the challenging IT services market. However, the order book in Q2 was, based on the comments made at the results announcement, relatively at the same level as in the comparison period, which is satisfactory, but the company needs to succeed in new sales to continue its growth path. Digia's EBITA increased from the weak comparison period to 4.2 MEUR or 8.1% of revenue (Q2'23 3.4 MEUR), missing our forecast of 4.9 MEUR. Profitability was weighed down by the company's investments, restructuring costs (0.3 MEUR), billing rates (compared to the previous quarter), and the recognition of additional purchase prices for acquisitions. Adjusted for the above-mentioned one-offs, the result was relatively in line with our forecasts. There were no surprises in other result rows. We estimate revenue growth of 7% in 2024, driven by acquisitions (4%). We expect EBITA to increase by 16% to 19.4 MEUR (9.5% of revenue), driven by revenue growth and improving profitability. The profitability improvement will be driven by higher billing rates. Q2 company update on Digia can be found here (in Finnish). 

Digital Workforce's revenue increased by 14% to 7.0 MEUR, beating our forecast for the second quarter. As we understand it, growth continued to be driven by healthcare in Finland, in line with the industry focus, and by the North American market, which is the geographic focus of the growth market. By business line, growth was driven by strong growth of 16% in scalable continuous services. Digital Workforce’s gross margin was 38% of revenue in Q2 and thus significantly improved from 33% in the same period last year and also from 36% in Q1'24. Profitability was supported by growth in higher-margin Continuous Services, the closure of the Danish and Norwegian offices at the end of last year and administrative efficiency measures. In other cost lines, investments weighed slightly on profitability. We expect that the company’s revenue will grow by 10% and EBITDA will be 1.2 MEUR or 5% of revenue in 2024 (2023 adj. EBITDA 0.2 MEUR). The Q2 company update on Digital Workforce is available here.

Gofore’s revenue was already known for Q2 and amounted to 48.0 MEUR, up 1% year-on-year. Organically, revenue decreased by 3%. Intense price competition limited growth opportunities as the company has not been willing to sacrifice too much on profitability. This is positive for the long term, as otherwise the quality of the order book would continue to deteriorate and it would take longer to return to growth when the market situation improves. Gofore's adjusted EBITA increased by 13% to 6.1 MEUR but missed our forecast. This corresponds to a satisfactory/good EBITA margin of 12.7% for the company under the circumstances, but at the very top end of the sector. We forecast organic revenue development of -1% and and a slight decline in EBITA-% to 13.8% in 2024. Profitability is weighed down by the negative equation of customer prices and wage inflation. Q2 company update on Gofore is available here (in Finnish).

Innofactor’s Q2 revenue declined by 1% and was slightly below our expectations. The company has been able to grow organically and faster than the industry for several quarters, but the difficult market situation inevitably slows down Innofactor as well. Adjusted EBITDA for Q2 decreased by more than 20% to 1.4 MEUR, corresponding to 7% of revenue and below our forecast of 9%. We adjusted for a one-time legal charge of 0.8 MEUR. According to our calculations, the result was limited by lower billing rates (revenue/employee/day -2% adjusted for materials and services). We forecast Innofactor's revenue to grow by 2% to 82 MEUR in 2024 and EBITDA to decrease to 7.5 MEUR or 9% of revenue (9.1 MEUR or 11.3% in 2023). As a result, our earnings forecast is relatively clearly below the guidance, but partly due to one-time factors. Q2 company update on Innofactor is available here. Later in July, a takeover bid for the company was announced, on which our update report can be read here.

Loihde's Q2 revenue grew stronger than expected by 3% to 35.4 MEUR (Inderes forecast: 33.7 MEUR). Below the surface, progress was very divided. In H1'24, Security Solutions grew by 13% and Cyber, Cloud & Connect by 10%, while Data & AI and Digital Services declined by 15% and 13% respectively. Adjusted EBITDA-% improved to 7.3% from a weak comparison period, well in line with our expectations, and, excluding adjustments, was slightly below our expectations. Profitability was weighed down by low utilization rates in the IT consulting areas, similar to the comparison period, while the security business areas' profitability improved significantly year-on-year and was also supported by organizational efficiency measures. We predict that Loihde will grow organically by 2% this year. We forecast the adjusted EBITA-% to rise to 2.9% in 2024 (2023: 0.5%). Wage inflation and a difficult-to-predict operating environment are clear barriers to earnings growth. The Q2 company update on Loihde is available here (in Finnish).

Netum's revenue increased by 31% to 11.3 MEUR in Q2, driven by the acquisition of Buutti, and was in line with our forecasts. Organic growth was 5%, a good performance in the current challenging market environment (sector Q2'24: -1%). Organic growth was driven by higher billing rates. EBITA was 0.9 MEUR or 8% of revenue, which is better than the sector average and well above the comparison period (sector 4% in Q2'24, comparison period 2%). Profitability was, however, slightly below our forecast (10%). Profitability was supported by organic growth and consequently higher billing rates, as well as a number of efficiency measures. The other earnings lines are only reported on a half-yearly basis, but in our view, there were no surprises. Other operating expenses in particular have become more efficient. We forecast revenue to grow by 22% and organically by 5% to 45 MEUR and EBITA-% to increase to 9.3%. The Q2 report on Netum is available here (in Finnish).

Siili's Q2 revenue decreased by 7% to 29 MEUR, which was in line with our estimate. The company only reports its geographic figures on a half-yearly basis, with international revenue down 2% (28% of revenue) and Finnish revenue down 12% in H1. The company's capacity fell slightly in Q2 from Q1, but Siili said it will hire in H2, especially for data and AI expertise. Adjusted EBITA was 1.7 MEUR, in line with the comparison period but below our forecast. Adjusted EBITA-% was therefore 6% and weak relative to the company's potential, but slightly improved relative to the comparison period and the previous quarter. However, given the relatively sharp revenue decline, the improvement in profitability was a good achievement. Due to the challenging market, we forecast a 4% decline in revenue to 117 MEUR in 2024, which is below the company's guidance. We also expect adjusted EBITA to decline to 7.2 MEUR (6.1% of revenue) due to unfavorable net developments in customer prices and wage inflation. The Q2 company update on Siili is available here (in Finnish).  

Solteq’s revenue decreased by 6% to 13.4 MEUR, slightly below our estimates, as a result of divestments. Comparatively, revenue decreased by 2%. At the segment level, Retail & Commerce's revenue decreased organically by 1% and Utilities' by 3%. It is critical for the company to return revenue to a growth path in order to put earnings growth and cash flow on a positive and more solid footing. Comparable EBIT-% was 0%, a significant improvement from the weak comparison period and also slightly better than in the previous quarter (Q1’24: -2%). As expected, Solteq also announced that it has commenced a procedure to amend the terms and conditions of its 23 MEUR notes due October 1, 2024. The total cost of the refinancing structure was slightly higher than expected, with a forecast interest rate of 12% and now an expected actual rate of 12.875%. We forecast marginal revenue growth in 2024 and an adjusted EBIT-% increase to 2% (2023: -6%), driven by billing rates, efficiency measures and an improved revenue structure. The Q2 company update on Solteq is available here, including more extensive comments on the refinancing (in Finnish). 

Tietoevry's revenue increased by 3% to 715 MEUR in Q2, which was in line with our and market expectations. Organic revenue grew by 1% but working-day adjusted revenue decreased by -1%. By business area, organic growth was best supported by Tietoevry Banking (+5%) and Tietoevry Industry (+5%). Tietoevry’s adjusted EBITA was 78 MEUR or 11% of revenue (Q2’23: 73 MEUR), which was well in line with our and consensus forecasts. The improvement in profitability was driven by organic growth and efficiency measures. However, non-recurring costs were higher than expected, driven by strategic assessments and restructuring costs. As a result, reported EBIT landed at 48 MEUR, below our forecast of 60 MEUR. We forecast the company's organic revenue growth to slow to 1% (4-6% in 2022-23), driven by a challenging market. We expect the adjusted EBITA margin to be 12.6% in 2024 (12.6% in 2023). Profitability is supported by a better revenue mix and lower employee turnover, but limited by wage inflation (4.5%), which is difficult to pass on to customer prices. Q2 company update on Tietoevry is available here.  

Vincit’s Q2 revenue decreased by 13% to 21.7 MEUR, slightly below our estimates. As in previous quarters, the slow development was due to weak demand, especially for customized software development. Geographically, revenue decreased by 13% in the Nordics and by just over 20% in the US. Vincit's result was well below our forecasts with an adjusted EBITA of -0.3 MEUR in Q2, whereas we had expected a clearly positive adjusted EBITA of 0.9 MEUR. Overall, the result was mainly burdened by lower revenue and fixed-price projects that were delayed. Reported EBITA for Q2 was -0.8 MEUR, including a one-off restructuring cost of approximately 0.5 MEUR for the US organization and write-downs of start-up risk projects. The performance of the product business is also very weak, and we find it difficult to see these investments creating shareholder value. All in all, the earnings development was weak and a definite disappointment for us, as we had expected a turn for the better. So far, efficiency measures alone have not yielded the desired results. A clear improvement in profitability will also require support from the revenue development. We forecast Vincit's revenue to decline by 8% to 91 MEUR and reported EBITA-% to rise only slightly to 2.2% of revenue (2023: 1.8%) Q2 company update on Vincit is available here (in Finnish).

Witted’s Q2 revenue decreased significantly (-16%) to 13.7 MEUR, which was fully in line with our expectations after knowing the April-May figures. Organically, revenue decreased by approximately 17%. The decrease was caused by the difficult market situation, which hit the company hard, while new sales, which have gradually picked up during the year, have not yet been reflected in revenue. Profitability continued to show an improving trend due to cost-saving measures and the adjusted EBITA-% increased to 3.5% (Q2’23: 1.6%), exceeding our expectations. The good profitability trend is driven by lower fixed costs thanks to savings measures, but also by an improved gross margin. Both segments improved their profitability and, in a positive development, revenue in Norway turned to a slight increase. However, the decline in the number of experts in the group continued to exceed our expectations in June. We forecast Witted's revenue to decline organically by 17% in 2024 and the adjusted EBITA margin to rise to 3.3% (2023: -0.2%), supported by improved gross margins and efficiency measures. The Q2 company update on Witted can be found here (in Finnish).