IT service sector: Mainly a strong start to the year

Translation: Original comment published in Finnish on 5/22/2023 at 5:00 am.

Customer demand still remained at a good level in Q1 for most of IT service sector companies. Many companies still saw uncertainty in the market, but it was concretely visible only in a few companies. However, when speaking about the market, it can be said that for the first time in years competition has shifted from experts to customers. In Q1, growth was still good in the sector's context and exceeded expectations. Especially positive was profitability, which exceeded our estimates in more than half of the companies. We also see conditions for healthy organic growth in the rest of the year and expect profitability levels to rise from the weak last year, although the next few quarters are subject to excepitonally high uncertainty in tighetend customer demand.

Growth continued at a good level in Q1 or even a very good level considering uncertainty

The Q1 earnings period of the domestic IT service sector was good, especially given the talk about uncertainty in customer demand that has continued for several quarters. Organic growth, which we monitor carefully actually accelerated slightly from the good Q4 level and was 10% (Q4’22 median: 9%). Average growth waned slightly and was 9% (Q4’22: 10%). As a whole, the companies exceeded our expectations slightly when 3 were above, 4 in line with and 2 below our estimates. Based on Q1 we can state that uncertainty has not yet been widely reflected in company numbers, more clearly only in a few (Witted, Solteq, Loihde) and many are relatively confident also concerning short-term demand. Vincit talks about and reacts to the uncertainty by reducing staff, although Q1 was still good.

The common denominators for the weakness in the sector are the declining demand for software development, weakness in sales, small private sector customers and companies that do not “own” their customers. Companies with deep customer relationships, those who are strategic partners, that operate in the public sector, have recurring business, long contracts, ERP business and, in general, those who produce critical solutions for customers fare well. In the big picture, it can be said that competition has shifted from experts to customers for the first time in several years. In addition, we believe growth was still supported by the already “cliché-like” topic but a relevant parameter, decreased expert attrition. Much has been said about price increases in recent years, especially last year. In the current environment it may be difficult to push through price increases and those who made them last year are well positioned. Now, we believe that prices are temporarily even falling due to tighter competition in some areas, such as software development. This year, success in sales is critical to growth and naturally the companies that already have invested in this hold a strong position. On the other hand, the companies whose particular strength has been strong talent recruitment are now benefiting relatively less than before.

Profitability exceeded expectations in Q1

The median adjusted EBIT margin for the sector was 8.8% in Q1 decreasing slightly year-on-year (Q1’22: 10.4%), when there basically was no uncertainty. As a whole, profitability levels exceeded our expectations quite clearly when 5 were above, 2 in line with and 2 below our estimates. Profitability was particularly limited by wage inflation and general cost inflation. Profitability relative to last year was supported by lower attrition and partly by higher customer prices. In general, the profitability level was, in our opinion, a good performance considering the difficult economic environment. In the market, a majority continued to perform well, or even very well, while for some the weak demand was apparent.

In 2023, we expect good performance on average in an uncertain economic environment

Despite the uncertainty surrounding demand, we expect organic growth in the IT service sector to continue on a sound basis and M&A transactions to clearly support growth. There is still uncertainty about private sector demand, and some areas within the market where only a few companies appear to suffer more clearly. Most companies commented that the demand outlook is more stable compared to last fall, when there was an exceptionally high degree of uncertainty. This year, the competitive advantages of companies will again be truly put to the test, not just in expert recruitment, when companies that are successful in sales have good growth opportunities in a less tight expert market. On the other hand, we feel that the customers of the companies have an exceptionally high effect on their demand outlook when, e.g., the demand outlook of the public sector and larger companies seems clearly more stable in general. Some companies whose customer focus has been especially in the private sector have for some time already focused their sales efforts more strongly on sectors with a stabler outlook, such as the public sector and large companies with greater stability.

We predict that the median revenue growth of the companies we monitor will be 13% and the average will be 16% (estimate in Q4: 12% and 16%). We estimate that the median of organic growth, which we monitor carefully, will be 8% and the average 9% (2022: 11% and 14%). Thus, the organic growth estimate increased slightly in Q1 (estimate in Q4: 6% and 9%). We expect that the median EBITA margin for the companies we monitor will rise to 9.2% from the low 7.1% level in the previous year. The companies that we monitor have previously made cautiously positive comments on increases in customer prices, which supports profitability, but right now it is more challenging. Relative to Q1, profitability is also limited by salary increases related to collective agreements that took effect for most companies in April. Some companies have their own collective agreements, and increases will take effect based on these. The profitability of the sector is as usual particularly limited by wage inflation, which Tietoevry estimates to be 4-5% in 2023. Increased price competition in some areas of expertise is also challenging, as most companies' costs are fixed in the short term. The price competition stems from increased customer demand and we estimate that next few quarters can be the toughest from this viewpoint. Many companies will have to adapt in some way to this changed situation, and predicting the next quarters is more challenging than usual. Demand returning to growth in affected areas is in the short term largely dependent on a general improvement in the economic outlook but we are quite confident already looking into the end of the year and next year.

Brief company specific Q1 comments and our 2023 estimates

Digia’s Q1 revenue grew by 18% from the comparison period, driven by strong organic growth (11 percentage points). Digia's new sales also progressed well in Q1, which was a continuation of good Q4 sales. The company again commented that its overall outlook is relatively stable. EBITA for Q1 was EUR 4.9 million exceeding our EUR 4.4 million estimate. EBITA was 9.7% of revenue and decreased from a strong comparison period (Q1’22: adj. 12.1%) but rose from weaker Q2-Q3’22 levels. The company’s guidance is that revenue and EBITA will increase from the previous year. 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 24% and the margin to rise to 10.3% (2022: 9.2%) from the weak comparison period driven by investments in the previous strategy period. Q1 company update on Digia can be found here (in Finnish).

Gofore's Q1 revenue increased by 39% driven by acquisitions and very strong organic growth (around 32%). Especially positive in the quarter was the increase in customer prices (+3.8%) relative to average wage inflation (+2.2%), which supported profitability in particular and which we suspect will continue to support it. Gofore's adjusted EBITA was very strong at 16.9% (sector median 7% in 2022). Profitability development was supported by price increases, improved billable utilization and the scaling down of fixed costs with strong growth. Last week, Gofore also published figures for April and the performance was again strong, especially in recruitment (+31 persons). We estimate that Gofore will grow by 28% in 2023, driven by strong organic growth (around 20%). We expect the EBITA margin to rise slightly to 15.0% in 2023 (2022: 14.7%). Profitability is supported by improved customer prices and billable utilization. Profitability is still limited by wage inflation, albeit less than before.

Innofactor's Q1 revenue grew strongly by 19% driven by organic growth (11%). We estimate that the order backlog (growth +7%) focused more on various product/geographic areas than before, and the company has also used more subcontracting, which supported the acceleration of organic growth in the latest quarters. The fact that 60 new young experts are recruited and will start work in Q2-Q3 was also positive as it will alleviates the expert shortage and mitigates wage inflation. EBITDA increased to EUR 2.5 million and exceeded our estimate while accounting for 12.3% of revenue. Supported by the Invenco acquisition, we expect Innofactor's revenue to grow by 12% to (organic 8%) and EBITDA to reach EUR 8.9 million (11.2% of revenue, 2022: 7.8 MEUR). Q1 company update on Innofactor is available here.

Loihde Group's Q1 revenue increased by some 13% to EUR 31.3 million (Inderes estimate: organically -2%). The revenue of digital development contracted by 1% as a whole. We estimate that revenue developed organically weaker than expected in both the security business (~+3%) and digital development (~-9%-10%). Q1 profitability was clearly below our expectations (adj. EBIT-% -6.1% vs. Inderes +1.5%). In security, profitability was depressed by non-recurring additional costs related to ERP implementation and postponement of a few significant projects, as well as utilization rate challenges in digital development. The challenges should be mainly short-term, and this is supported by the company's unchanged guidance. Loihde comments that the demand outlook is still positive in Security and that Digital development's order backlog has strengthened and there it expects revenue to return to growth in H2. The company is quite confident that the revenue in Digital development will return to growth and Loihde repeated its guidance that expects a lot in terms of profitability during the remainder of the year. We expect Loihde’s revenue to grow supported by acquisitions by 14% (organic 3%) and adj. EBITA to decrease to EUR 2.5 million (1.8% of revenue, 2022: 4.0 MEUR). When comparing Loihde's profitability with other companies, it is limited by the large proportion of physical security that structurally has lower margins.

Siili's Q1 revenue grew by 15% and was fully in line with our expectations. Organic growth was at a good 9% level, especially considering the challenges of a few project deliveries. Siili's EBITA was EUR 3.3 million in Q1 and slightly above our estimate. The EBITA margin was 10.0% and fell as expected from the strong comparison period (Q1’22: 11.9%). Profitability and billable utilization were, like revenue, depressed by a few project overshoots. Siili expects 2023 revenue to be EUR 125–145 million and adjusted EBITA EUR 12-15.5 million, which represents an increase of 6–23% and an EBITA margin of 8.3–12.4%. We estimate revenue to grow by 12% to EUR 133 million in 2023 supported by acquisitions (organic 8 percentage points). In addition, we expect adjusted EBITA to rise to EUR 13.3 million or 10.0% of revenue, driven by growth in international operations (2022: 9.8%).

Solteq 's Q1 revenue decreased by 12%, which was below our expectations, depressed by both businesses. However, the demand decline in Retail & Commerce has now calmed down and the company also had sales successes. For Utilities, the company expects the situation to be clearly better after summer, which requires a sharp turn. EBIT was -0.5% of revenue and exceeded our estimate. At the beginning of May, Solteq carried out a business divestment that improves its balance sheet position in Q2, thereby reducing the risk of refinancing. Solteq naturally withdrew its guidance in connection with the business divestment and provided new guidance in connection with Q1. The company estimates revenue to be EUR 60–62 million, and EBIT adjusted for the EUR 8 million sales gain to be slightly negative. The guidance was in line with our previous estimates and the report only gave rise to minor estimate adjustments. We expect Solteq's revenue to fall by 12% to EUR 60 million driven by the divestment. We also expect adjusted EBIT to be slightly in the red in 2023, driven especially by the challenges in the Utilities segment and divestment of the profitable business.

Tietoevry's Q1 revenue grew by 2% as expected and organically by 8% which is strong for the company. Growth was driven by cloud computing and software products and limited as usual by Transform and Connect businesses. Adjusted EBIT was 12.3% of revenue in Q1, which was supported by efficiency measures and limited by high inflation. The company’s guidance is that organic growth will be 5-7% and adjusted EBITA % 13.0-13.5% in 2023. We expect the company to grow 3% (organically by 6.6%) and achieve an EBITA margin of 13.3% in 2023. Q1 company report on Tietoevry is available here.

Vincit's revenue increased by 59%, driven by organic growth (+10%) and exceeded our estimate. In Q4, the company warned that organic growth would be more moderate and that it would invest in profitability, which proved cautious in terms of growth and promises were delivered in terms of profitability. The number of personnel decreased in the quarter and the company commented that it had adapted it to the current demand environment and was cautious in recruitment. Vincit’s guidance indicates that revenue will be over EUR 105 million and EBITA 7-11% of revenue in 2023. The revenue guidance indicates at least 5% organic growth. We expect Vincit to grow by 27% (organically by 7%) to EUR 107 million in 2023, driven by higher customer prices and billable utilization. We also expect EBITA % to rise to 8.4% in 2023, driven by extensive cost saving and billable utilization.

Witted's Q1 revenue grew more strongly than we expected by 48% (Inderes: +37%) supported by the Nexec acquisition. Organically growth slowed down clearly less than expected to 19% (Inderes: +7%, Q4’22: +33%). We estimate that organic growth also continued relative to Q4, so the company has been able to maintain some growth also in a weaker demand environment. The EBITA margin was -0.9% (Q1’22: 3.2%), which was 2.5% below our estimate due to, e.g., lower billable utilization. This year, the company is also seriously focusing on strengthening profitability, and we believe that the billing challenges can be resolved relatively quickly. In 2023, we expect Witted's revenue to grow by 36% (organically 17%) to EUR 72 million and EBITA will be clearly positive at 1.0% of revenue (2022: 0.5%). The company’s key challenge is now to strengthen its sales machine and succeed in winning customer projects better than its competitors without compromising its margins too much.