IT service sector: Our expectations for 2024 generally at the lower end of companies' guidance

Translation: Original comment published in Finnish on 4/5/2024 at 7:14 am EEST.

Our forecasts for 2024 are virtually unchanged, with Q4 well in line with expectations. We estimate that listed IT service companies will grow moderately in 2024, but well below historical growth rates. We expect the dual dynamics to still continue, but different company profiles than in the past are likely to thrive in the changed market environment. In our estimate, the demand environment remains cautious and waiting. Price pressure in particular is a challenge. However, the trend of digitalization is not stopping and there are still areas of faster growth when the development of critical activities cannot be stopped. We expect profitability in the sector to improve slightly, driven by cost savings, but still stay below potential due to price pressure and challenges in managing billing rates. Overall, our expectations for 2024 are generally at the lower end of companies' guidance.

In 2024, we expect growth to remain moderate and clearly slower than in previous years

Our growth forecasts for 2024 remain largely unchanged after the Q4 reports. We expect median organic growth in the IT service sector to be +2% and average growth to be close to zero (2% and 2% after Q3'23 reports). In addition, we expect only modest growth support from acquisitions. While acquisitions are expected to take place this year, their catalytic effect is likely to be well below historical levels. Part of the weaker growth is also due to strong comparison figures in the first quarter. We thus forecast growth to be significantly slower than in the previous 6 years (2023: 0 % and 2018-2022: 8-16 %). There is still considerable uncertainty surrounding the market situation and customer demand, and especially customer prices. Several companies announced in their Q4 reports that they have entered into price competition, to our understanding mainly in the public sector, which means that the market can currently be described as unhealthy. As a result, our forecasts are naturally still subject to a high degree of uncertainty.

In 2024, we estimate that companies will continue to develop in different categories based on their different profiles. We expect the performance of companies with a profile of software development and a stronger private sector focus to remain relatively weaker in 2024 (Witted, Vincit, Siili). By contrast, we expect companies operating in the public sector and in the more traditional IT service areas to perform relatively better (Netum, Innofactor, Gofore, Digia, Solteq). For these companies, a clearly higher share of revenue is recurring or based on long-term contracts, which is true also for Digital Workforce. In summary, companies that used to grow more slowly are now doing relatively better, and vice versa.

Of the listed companies, 9 out of 11 provide guidance for 2024. Gofore and Witted do not provide guidance. Of the companies providing guidance, only two foresee the possibility of a decline in revenue (Siili and Vincit). As a whole, our forecasts are generally at the low end of the revenue guidance range. The companies' guidance generally points to an improvement in profitability or absolute result in 2024. Only Tietoevry's guidance includes the possibility of a slight decline in profitability or result.

Source: Companies and Inderes

Demand environment remains challenging, focus on sales rather than talent

In terms of market dynamics, it can still be said that for the first time in many years, competition has clearly shifted from talent to customers. With this competitive shift from experts to customers, success in sales is critical for growth. Naturally, the companies that have invested in this in the past hold a strong position. In other words, the companies whose particular strength has been strong talent recruitment are now benefiting relatively less than before. In the talent market, revenue will remain low and there is more talent available now than in years for those areas where sales are strong and customer demand is high. In the short term, we believe that the demand outlook for the sector is dependent on a general improvement in the macroeconomic outlook. In the medium to long term, the demand outlook for the sector remains good.

Most of the slowdown in demand, as we understand it, is due to projects being halted and postponed, rather than canceled. This means that a large part of the demand is simply carried forward and that investments will be made in the future. We expect that, like the decline, this could start to unwind relatively quickly as the economic outlook improves. Some operators also keep staff "on the bench", waiting for deliveries to start, which has a negative impact on billing rates and therefore especially on profitability. This is also believed to have contributed in part to more companies entering into price competition in Q4 in an effort to get the "benched" talent to work, rather than resorting to layoffs or redundancies. However, with the higher interest rate environment, it is also reasonable to assume that the expected return on customers' development projects has increased. This means that all the more speculative development projects planned earlier may not get off the ground in the new monetary environment.

Many customer sectors are still struggling and the investment threshold is tougher than before, but there are also grounds for mild optimism. Interest rate cuts are expected to come relatively soon, and consumer purchasing power is expected to develop positively this year. There are also very successful industries such as finance and insurance, security and energy. The industrial sector is fragmented, but the global economy has also shown promising signals, which could particularly help export-oriented industrial companies.

The public sector is living its own cycle, we believe, and it 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 still accelerating. Thus, we estimate that demand in the public sector as a whole will remain at a good level. In our view, the decline in demand that we saw last year, albeit rapid in places, is just a normal cyclical feature of the economy and has hit only part of the market harder.

Several areas continue to perform well. In this market situation, projects that are business-critical (such as data and analytics as well as demand for ERP systems) or that can achieve cost savings are in vogue, while new development projects are now being launched much less frequently. 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, however, it will open up new opportunities for growth. We suspect that it is difficult for IT service companies in the big picture to seek a competitive advantage from AI compared to each other, but we believe that its use is very critical to stay ahead of the competition.

We forecast profitability to improve slightly driven by cost savings

We estimate the median EBITA margin of the companies we follow to be 7.4% (7.2% after Q3'23). Thus, we expect profitability to be in the mid-range of the last 6 years and to improve slightly year-on-year (2023: 6.9% and 2018-2022 5.5-9.6%, or 7.5% on average). The improvement in profitability is mainly driven by efficiency measures taken by several companies and the resulting adjustment in personnel numbers, which drives better billing rates. However, the uncertain and rapidly changing demand environment continues to present challenges in managing billing rates. In addition, falling customer prices are putting pressure on profitability, even though wage inflation is also low in a historical context. In our estimate, wage inflation will be more moderate than it has been for many years. Tietoevry expects its wage inflation to be 4-5% in 2024 (5% in 2023), albeit driven more strongly by markets outside the Nordic region. In addition, Gofore's wage cost change was +3.6% in 2023 and 3.2% in Q4, indicating a downward trend. A slowdown in wage growth seems logical in the continued challenging market environment.

Source: Companies and Inderes

A comprehensive summary of the IT services sector and company-by-company comments on the Q4 results can be found here.

Other Nordic IT service companies provide guidance much less frequently

IT service companies in the other Nordic countries are clearly less likely to give guidance than their Finnish counterparts. Only 3 out of 14 companies issue guidance for 2024, and most rely on financial targets. The guidance does not really provide a comprehensive sample, but it does indicate better growth than the average Finnish company.

Of course, Sweden is partly affected by the same trends as Finland, and there is also a duality in the market. Some companies are doing well, while others face challenges created by the market. Comments suggest that the market seems to have weakened somewhat at the end of 2023. For example, Knowit commented that the Nordic consulting market has continued to weaken, especially in Sweden, where demand has weakened in several segments. By customer sector, Knowit commented that the demand in manufacturing, defense industry, and cybersecurity is good, while retail and parts of the public sector are weaker. In response to the more challenging demand environment, a number of companies commented that they would focus specifically on sales this year.

The M&A transaction market in the other Nordic countries appears to be improving, based on Q4 comments from the companies we monitor. The improvement in the M&A market has been driven by a narrowing of the gap between buyers' and sellers' expectations and the stabilization of financing costs, which has eased pricing.