Q3 IT service sector summary: Revenue down but profitability up – sector shows clear divide

Translation: Original published in Finnish on 11/15/2024 at 4:26 pm EET.

The IT services sector's Q3 results were met with a cautious mood after five companies in the sector issued profit warnings in just over a month. The decline in working day-adjusted organic revenue development for the sector's companies accelerated slightly as customers continued to economize, although the comparison period was already weak for most of them. Profitability, on the other hand, was significantly higher year-on-year, but the group was clearly divided between strong and weak performers. On the whole, the trends in Q3 remained similar to previous quarters. Our major concern is still the fierce price competition resulting from overcapacity, especially in public sector tenders. The longer price competition continues, the deeper it will cut into companies' order books and the slower the recovery will be. The quarter-on-quarter decline in the number of employees remained more moderate than at the turn of the year, with some companies already starting to hire in Q3. This gives some confidence that the trough in demand is near, but we believe that a more pronounced strengthening of the demand picture will require some traction from the Finnish and European economies.

Working-day adjusted organic revenue trend continued to weaken against expectations in Q3 – but small cluster did well

The weakness of Q3 and the rest of the year became clearer the closer we got to the Q3 reports, when 5 companies (Innofactor, Siili, Solteq, Tietoevry and Vincit) issued profit warnings in just over a month. As a whole, revenues in the Finnish IT services sector developed slightly weaker than we expected in a still difficult market environment. The comparison period was easier than in H1, as the market weakness had already impacted figures across the board in the spring of last year. Revenue of the companies in our coverage declined organically by 3%, a steeper decline than in Q2 (-1%). Progress was constrained by customers' need to save money, which led to IT projects being put on hold and launches being postponed. 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 deteriorated slightly from the previous quarter (Q2: -3% vs. Q1: 0%). On the other hand, this working day coincided with the holiday season in July, which in practice meant that the impact was much smaller. Overall, therefore, revenues were weaker than expected in Q3, with 1 company above, 4 in line with and 5 below our forecast.

Source: Inderes

In the big picture, the trends were the same as in previous quarters. Given the challenging market situation, 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. These include Digia, Netum and Loihde. However, the best growth was again seen in Digital Workforce (10%), where demand for its automation offering is strong. 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 still clearly reflected in the development of the companies' revenue, although the comparison period was already easier. There remains a clear 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, sufficient delivery capacity and/or the specialized expertise required by the customer. In general, we expect companies with clear competitive advantages to stand out more prominently in the future. The losers will be companies that lack critical (e.g., data, AI) or differentiating capabilities, deep customer relationships (management consulting, integration and continuity services contribute), or a deep understanding of the customer's business through industry focus.

Source: Inderes

Price competition due to overcapacity has remained fierce, especially in the public sector, and this is our main concern for the sector. Price competition is putting pressure on profitability in the IT services sector, while wages do not show a similar elasticity. 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 continued (-1%) in Q3 but has slowed compared to the turn of last year (Q4’23: -4% and Q1’24: -2%). This gives some confidence that the bottom of demand is near. The number of employees increased at Digital Workforce, Gofore and Vincit in Q3.

Source: Inderes

Note: 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. Loihde's employee numbers in Q1 and Q3 are estimated based on the average of Q4 and Q2, as the company does not report this figure on a quarterly basis. 

Profitability improved, but clear divide between strong and weak performers in Q3

The sector's average adjusted EBIT margin increased to 7.3% in Q3 from 4.7% in the comparison period and 5.1% in the previous quarter. Although the comparison periods were weak, the level of profitability in Q3 can already be considered close to good. In fact, several companies achieved significant improvements in profitability. The improvement in profitability was due to what we believe to be improved billing rates in the context of the sector, as well as cost-saving measures. In the comparison period, the weakening demand was already evident in the revenue development, but the efficiency measures only started to show more clearly in Q3'23. As a consequence, the impact of the efficiency measures only became visible later. Many companies have continued to see their revenue fall sharply, which has forced them to maintain strict cost discipline.

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.

Profitability in Q3 was very clearly split between the strong and the weak, with the historical average (7-9%) absent. Netum, Tietoevry, Digia and Gofore all reported strong profitability, all above 10%. This is partly explained by the relatively high share of recurring business in the companies, the software business (Digia and Tietoevry), and the stable public sector contract portfolio across the board (although there is price pressure on new contracts). The underperforming companies in the sector have definite potential to improve their profitability once the revenue decline is overcome. Digital Workforce is currently growing strongly, but growth investments are limiting the company's profitability development.

Forecasting profitability on a quarterly basis is challenging at the moment, as the revenue trend is uncertain and has a leverage effect on profitability. In addition, it is difficult to assess the timing of the effects of the various efficiency measures. Thus, as a whole, profitability levels were a little better than we expected, with 5 companies above, 1 in line (within 1 percentage point) and 4 below our forecast. However, the combined net effect of profitability outperformance (overruns + underruns) was positive + 7.0 percentage points. Profitability was supported by the cost-saving measures taken by the companies last year. However, profitability came under pressure from a stronger-than-expected decline in customer demand and, in particular, from fierce price competition, while wages are not adjusting in the same proportion. If the weakness in demand spreads to further 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 additional 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

Average profitability in the sector rose to near-historic levels (6-year average 7.5%), well above the low levels of the past year (5-6%). 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 2025 in the near future.

 

Source: Inderes

Brief company-specific Q3 comments

Digia's Q3 revenue increased by 11% over the comparison period to 45.4 MEUR, slightly above our expectations. Organic growth strengthened slightly from previous quarters to 5%, a very good level indeed considering the challenging IT services market. Digia's EBITA increased by more than 60% from the comparison period to 5.7 MEUR and was far above our forecast. The result was supported by improved billing rates, efficiency measures in Q2 and the organizational efficiencies enabled by investments in the company's ERP system in previous years. We estimate revenue growth of 7% in 2024, driven by acquisitions (5%) and supported by organic growth. We predict that EBITA will increase by 25% to 21.0 MEUR, driven by revenue growth and profitability. Q3 company update on Digia can be found here (in Finnish). 

Digital Workforce's revenue grew by 10% to 6.6 MEUR in Q3, fully in line with our expectations. Among the business lines, revenue in the more important Continuous Services continued to grow strongly (16%) to 4.4 MEUR, while Professional Services decreased by 1% to 2.2 MEUR in Q3. EBITDA-% was 2.7%, which was in line with Q2 but below our forecast of 5%. Relative to the comparison period (-1%), the improvement in profitability was supported by the closure of the Danish and Norwegian offices at the end of last year, administrative efficiency measures and revenue growth. The improvement in profitability was limited by accelerated investments in AI-based solutions and new hiring. We expect that the company’s revenue will grow by 10% and EBITDA will be 1.0 MEUR or 4% of revenue in 2024 (2023 adj. EBITDA 0.2 MEUR). The Q3 company update on Digital Workforce is available here.

Gofore’s revenue in Q3 decreased organically by 4% from the reference period and stood at 39.1 MEUR. Revenue development was restrained in particular by the fierce price competition in the sector. Initial signs of an upturn in customer activity were seen in September with the first major hiring round in a long time. Adjusted EBITA-% was 11.2%, a weak level for the company, but still strong in the sector context (sector 2022–2023: ~7%). Profitability was weighed down by pressure on billing rates, particularly in the DACH region, due to what we believe to be weaker demand. However, especially positive is the fact that Gofore managed to balance the development between customer prices (-0.5%) and wages (-1.0%). We project organic revenue growth of -3% for Gofore in 2024. In terms of profitability, we expect EBITA-% to decline to 13.2% in the current year, constrained by weaker billing rates and a negative equation between customer prices and wage inflation. Q3 company update on Gofore is available here (in Finnish).

Loihde's Q3 revenue grew better than expected by 5% to 31.5 MEUR (forecast: 29.8 MEUR). Growth was driven by Security Solutions and Cyber, Cloud and Connect, while revenue from IT consulting was still clearly down in a difficult market. Adjusted EBITDA of 2.9 MEUR (9.3% of revenue) remained at last year's level, exceeding our estimate of 2.3 MEUR. In our view, the good development in Q3 compared to the market environment is mainly due to organizational efficiency measures and growth in high-margin continuous services, but also to the more front-loaded revenue from security solutions than in a typical year, which will reduce the performance in Q4. On the other hand, we believe that cost inflation and price pressure seen in IT consulting will continue to be a significant headwind to profitability. We forecast Loihde's revenue to grow by 2% organically in 2024. In terms of profitability, we expect EBITA-% to rise to 2.6% from last year's weak level. The Q3 company update on Loihde is available here (in Finnish).

Netum’s revenue increased by 18% to 9.7 MEUR in Q3, driven by the acquisition of Buutti and somewhat below our expectations. Organic growth was 4%, a good performance nevertheless in the current challenging market environment and outperforming the sector. The growth in revenue was supported by continued strong demand from existing customers, more efficient new customer acquisition and an increase in invoicing rates.  EBITA was 1.4 MEUR, or 14.5% of revenue, which is among the highest in the sector in Q3 and well above our forecast of 9.4% (Q3 sector ~6%, comparison period 6%).  Profitability was supported by organic growth and, due to the reduction in the number of employees, in particular by the increase in invoicing rates. Additional support for the profitability came from efficiency measures taken last year and at the beginning of this year and, in our estimation, by the release of provisions for holiday pay. We forecast revenue of 44 MEUR, slightly below guidance, and an EBITA-% of 10.9%, right at the upper end of the guidance range. The Q3 report on Netum is available here (in Finnish).

Siili's Q3 revenue decreased by 11% to 24.1 MEUR, which was below our estimate. The challenging market situation has hit exactly where Siili's strengths lie. The company's number of employees decreased by 25 in Q3 from Q2, although Siili said in Q2 that it would hire towards the end of the year, especially for data and AI expertise. Adjusted EBITA-% was a weak 2.9%, down from 5.9% in the previous quarter. Siili is thus seeing a downward trend in revenue and profitability, although the comparison period was easier. In our view, there is a clear need for further efficiency measures at Siili, but the company does not seem to want to resort to them. This is positive in terms of employee image. However, profitability will remain under significant pressure until market demand and the pricing environment improve. We now expect Scanfil's revenue to decline by 10% to 110 MEUR and adjusted EBITA to stand at 4.5 MEUR in 2024. This means that the earnings guidance is again at risk. The Q3 company update on Siili is available here (in Finnish).   

Solteq’s revenue decreased by 7% to 11.4 MEUR, below our estimates. The company commented that the weaker than expected revenue development was the result of a slow recovery in customer demand, which we also heard widely from other companies in the sector. Comparable EBIT-% was 5%, an improvement from the comparison period and also better than in the previous quarter (Q2’24: 0%). Profitability was supported in particular by the efficiency program (3.4 MEUR) implemented in Q2. 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. We forecast revenue to decline by 10% in 2024, but profitability to improve markedly from the weak comparison period, supported by the substantial cost savings implemented in Q2 and an improved revenue structure. Q3 company update on Solteq is available here (in Finnish). 

Tietoevry's revenue decreased by 1% to 655 MEUR, slightly below our forecasts before the guidance downgrade, but in line with our updated forecasts. Organically, revenue decreased by 1%. The company said the decline in demand has spread to more geographic markets and more activities. This means that the weakness is much more widespread than in the past. Tietoevry’s adjusted EBITA was 88 MEUR or 13.5% of revenue (Q2’23: 73 MEUR). The result was therefore slightly above our and pre-warning consensus forecasts, but in line with our subsequently updated forecasts. The improvement in profitability was driven by efficiency improvements in all businesses. In addition, Tietoevry said that the strategic review of the Tech Services business is progressing and that the company is in exclusive negotiations with a non-industrial player. We expect organic revenue to decline this year and next. In addition, we expect the company's adjusted EBITA margin to be close to 13% in the coming years, supported by ongoing efficiency measures. The Q3 company update on Tietoevry and more detailed comments on the sale of Tech Services can be read here.  

Vincit’s Q3 revenue decreased by 15% to 18.4 MEUR, missing our estimates. As in previous quarters, the slow development was due to weak demand, especially for customized software development, but also to a general slowness in customers' decision-making towards the end of the year. Invoicing rates were good in the summer, but bench time deteriorated again during the quarter, which the company is now trying to address with layoffs. Profitability fell to 4.4% from 6.3% last year. Nevertheless, the level of profitability was quite good relative to the lower revenue. However, the moderate profitability of the quarter combined with the profit warning underlines the difficult outlook for the rest of the year. We expect revenue to fall by 15% in 2024 and EBITA-% to end up at 0.9%, which is a very weak level. Q3 company update on Vincit is available here (in Finnish).

Witted’s Q3 revenue decreased by 16% to 11.4 MEUR (Q1'23: 13.6 MEUR), slightly below our forecast of 11.6 MEUR bearing in mind that the July-August revenue figures were already known. By segment, revenue in Finland continued to fall sharply (estimate ~-21%), while international revenue was roughly at the previous year's level. The most notable disappointment was the decline in the number of experts to 330, whereas we had expected the number to remain at the Q2 level of 337. Adjusted EBITA-% was 2.1%, a clear improvement over the weak comparison period (-2.0%), but slightly below our estimate of 3.2%. The improvement in profitability was supported by cost savings achieved and improved sales margins. The company also commented that their bench situation was even excellent after the summer, which should provide a good starting point for profitability for the rest of the year. The profitability level in Finland continued to show a good trend, but internationally it remained negative and below our expectations, largely due to the different seasonality of holiday pay provisions in Norway compared to Finland. We forecast Witted's revenue to decline by 17% organically in 2024. In terms of profitability, we expect EBITA-% to rise to 2.8% from last year's weak level. The Q3 company update on Witted can be found here (in Finnish).