IT service sector Q1 summary: Revenue and profitability down from a strong comparison period, but some defensive wins in profitability as well

Translation: Original comment published in Finnish on 5/20/2024 at 7:59 am EEST.

The organic revenue development of the Finnish listed IT service companies took a downturn from a strong comparison period. At the same time, profitability declined from the good comparison period, although slightly less than expected, helped by cost savings. Adjusted for working days, organic development was flat year-on-year and profitability was slightly better than reported. Overall, the trends in Q1 were similar to previous quarters. Our main concern still relates to fierce price competition, which seems to have spread to the majority of players in the sector. In the short term, we expect competition to remain intense, but we believe that the strengthening of the general economic development in Finland and Europe and the likely decline in interest rates will create the necessary conditions for a gradual improvement in the demand outlook over the next year.

Organic revenue turned down, slightly below our expectations

In Q1, revenues in the Finnish IT services sector developed slightly weaker than we expected in a difficult market environment. Revenue of the companies in our coverage declined organically by 2%, a slight deterioration from Q4 (0%). The weaker development was partly due to a strong comparison period and again (also in Q2-Q4) one working day less than in the previous year (an impact of just under 2% per quarter). Thus, the calendar-adjusted organic development was around the level of the comparison period. Overall, revenues were slightly weaker than expected in Q1, with 2 companies above, 5 in line with and 4 below our forecast. Exchange rates (SEK and NOK) were no longer a major headwind. 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 one working day more in Q2 and Q3 than in the comparison period, which supports revenue and especially profitability.

Source: Inderes

In the big picture, the trend in Q1 was the same as in previous quarters. There continued to be large differences between companies. Netum grew 7% organically and a few companies saw their revenue decline organically by as much as 10-20%. As the market situation became more challenging last year, the companies with more recurring revenue, deep and strategic customer relationships, those operating in the public sector, those with long term contracts, 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. In recent quarters, the market has also indicated that buyers 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.

Price competition remains fierce, and to some extent has expanded in recent quarters as several listed companies have also entered the fray. This is our main concern for the sector. Price competition puts pressure on profitability when wages aren't adjusted in the same way. 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. Interest rates (Euribor) are expected to fall by around 1 pp next year and the Finnish economy (GDP) is expected to return to modest growth towards the end of the year, while the demand outlook for many global customers has improved and economic forecasts in Europe have also been slightly on the rise. Against this backdrop, we believe that the prospects for strengthening demand over the next year are good, as the need for digital investment remains as strong as ever. In the short term, however, it is very difficult to predict how demand will develop in the sector.

Cost savings helped in Q1 and profitability declined slightly less than expected

The sector's average adjusted EBIT margin was 6.4% in Q1 (median 5.4%), slightly down from the comparison period (average 6.8% and median 8.8%). In the comparison period, demand was still good and profitability was also at a good level. So, in a sense, the decline was relatively moderate. The median profitability declined much more than the average. However, 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. As a whole, profitability levels were slightly better than we expected, with 4 companies above, 4 in line (within 1 percentage point), and 3 below our forecast. Profitability was supported by the cost savings the companies made last year. Profitability remained under pressure from falling customer demand, intense price competition and wage inflation. In addition, one less working day compared to the previous year put pressure on profitability. If the weakness in demand spreads to new areas of expertise and/or customer sectors, new change negotiations are likely. 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 (7%) 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

Brief company-specific Q1 comments

Digia's Q1 revenue increased by 7% from the comparison period to 54 MEUR, in line with our expectations. Organic growth was 2% (Q4’23 3%). The growth was supported by the Top of Minds acquisition, which drove the international business to 12.3% of revenue. EBITA-% was 10.3%, which was above our estimates. Profitability improved thus slightly year-on-year as well as from the previous quarter (Q1'23 9.7% and Q4'23 9.6%). We estimate that the profitability improvement was driven by better billing rates. We forecast revenue growth of 5% in 2024, driven by acquisitions (4%). We expect EBITA to increase by 19% to 19.9 MEUR (9.9% of revenue), driven by revenue growth and improving profitability. The profitability improvement will be driven by higher billing rates. Q1 company update on Digia can be found here (in Finnish).

Digital Workforce's revenue increased by 3% to 6.7 MEUR, beating our forecast for the first quarter. In line with the industry focus, growth was driven by healthcare and the North American market, the geographic focus of the growth market. In addition, the company has announced significant contracts in these areas in recent months, which should support further development. EBITDA was 0.29 MEUR, almost double our forecast. EBITDA margin was 4%, up from the end of last year (H2'23 adj. -2%). Profitability was supported by higher revenue (higher billing rates as headcount decreased) and a number of efficiency measures implemented last year. We expect that the company’s revenue will grow by 7% and EBITDA will be 1.4 MEUR or 5% of revenue in 2024 (2023 adj. EBITDA 0.2 MEUR). The Q1 company update on Digital Workforce is available here.

Gofore's Q1 revenue was at the level of the comparison period at 49 MEUR. Organically, revenue decreased by 2%, but adjusted for working days, it was on level with the comparison period. Geographically, international revenue decreased the most in Q1 (-19%), but the company is confident for the rest of the year. Adjusted EBITA decreased by 18% to 6.8 MEUR, but clearly exceeded our forecast of 5.0 MEUR. This corresponds to a strong EBITA margin of 13.8% under the circumstances, which is at the top of the sector's range. In recent quarters, the company has managed to cut overheads better than we expected. In Q1, the company once again demonstrated that it has its profitability under control, despite a sharp slowdown in revenue (organic growth Q3’23 20% vs. -2% in Q1’24). We forecast organic revenue growth of 1% and an EBITA-% of 14.0% in 2024, in line with the comparison period. The Q1 company update on Gofore is available here and a comment on April figures here (in Finnish).

Innofactor’s Q1 revenue grew organically by 5% to 21 MEUR). The growth rate was particularly positive in the current challenging market situation. Geographically, revenue increased in Finland (just under 10%) and Norway (~20%) but decreased slightly in Sweden and especially in Denmark (~80%). Among the solution areas, Information and Case Management and Digital Services are the top performers, driving revenue and earnings growth. Comparable EBITDA increased by 5% to 2.6 MEUR, which slightly exceeded our estimate and accounted for 12.3% of revenue. We forecast Innofactor's revenue to grow by 3% to 83 MEUR in 2024 and EBITDA to increase to 9.7 MEUR or 11.7% of revenue (9.1 MEUR or 11.3% in 2023). Q1 company update on Innofactor is available here.

In a seasonally weaker Q1 (due to the security business), Loihde's revenue increased stronger than expected (31.7 MEUR) to 33.0 MEUR (+6%; Q1'23: 31.3 MEUR), driven by Security Solutions and Cyber, Cloud & Connect business areas. In Digital Services and Data & AI, revenue declined markedly. Profitability improved significantly from the weak comparison period (adj. EBITDA % 0.4%), but slightly missed our forecast (adj. EBITDA-% 4.8% vs. forecast 6.5%), driven by lower than expected billing rates. In the comparison period, the challenges of the ERP implementation in particular weighed on both revenue and profitability. Overall, the company seems to be emerging relatively unscathed from the difficult market situation with its stable security business, although profitability is still under pressure from several directions. We expect Loihde's revenue to be almost at the previous year's level of 134 MEUR in 2024 (1% organic growth). We forecast adjusted EBITA-% to increase to 2.9% in 2024, driven by the resolution of ERP issues, improved billing rates in digital development and organizational efficiency measures (2023: 0.5%). Wage inflation and a difficult-to-predict operating environment are clear barriers to earnings growth. The Q1 company update on Loihde is available here (in Finnish).

Netum’s revenue increased by 35% to 11.4 MEUR in Q1, driven by the acquisition of Buutti. Organic growth was 7%, a good performance in the current challenging market environment (sector H2'24 0-2%), although slightly below our forecasts. EBITA was 1.4 MEUR, or 12.4% of revenue, a strong performance in the context of the sector (~7%) and well above our forecast of 1.1 MEUR. Profitability improved clearly from the comparison period (8.8%), but especially from the end of last year (H2 7.8%). Profitability was supported by organic growth and consequently higher billing rates, as well as a number of efficiency measures. In 2024, we forecast revenue growth of 22%, driven by the Buutti acquisition (17 pp) and organically at a healthy rate of 5% in the sector context. In addition, we expect EBITA-% to rise to just over 10% in 2024 (2023: 7.4%), supported by cost savings and billing rates. The Q1 report on Netum is available here (in Finnish).

Siili’s Q1 revenue decreased by 11% to 29.8 MEUR and was below our expectations. The market weakness has hit the areas of expertise that are important to Siili Solutions. In Q1, the weakness was particularly evident in the Finnish public sector and in the international operations. We understand that demand from financial and industrial customers has been relatively better. Adjusted EBITA decreased significantly year-on-year (~50%) and was 5.3% of revenue in Q1 (Q1'23 10.0 %). In our view, the Q1 result was a distinct disappointment given the two change negotiations and other adjustment measures implemented last year and the cost savings they were expected to deliver. For 2024, we forecast revenue to decline by 4% to 118 MEUR, below guidance in a challenging market. We also expect adjusted EBITA to decline to 7.7 MEUR (6.4% of revenue) due to unfavorable net developments in customer prices and wage inflation. The Q1 company update on Siili is available here (in Finnish).  

Solteq’s revenue decreased by 20% to 13.6 MEUR, as a result of divestments, which was below our expectations. Comparatively, revenue decreased by 4%, driven by both segments. Comparable EBIT was -0.2 MEUR, or -2% of revenue, and improved from the previous quarter (Q4'23 -7%), but was below our forecast. Solteq's current year still looks difficult in terms of operational drivers and Q1 definitely left room for improvement for the rest of the year in order to reach guidance. We forecast comparable revenue to grow marginally and EBIT to reach 1.3 MEUR, or 2.4% of revenue, supported by new cost savings. Q1 company update on Solteq is available here (in Finnish). 

Tietoevry's revenue decreased by 1% to 734 MEUR, in line with our expectations. Organically, revenue decreased by 2%. Tietoevry’s adjusted EBITA was 89 MEUR or 12.1% of revenue (Q1’23: 92 MEUR), which was perfectly in line with our and consensus forecasts. In our view, maintaining profitability close to the prior-year level was a very good performance given the lower revenue and cost inflation. The biggest news was that the Banking business will unexpectedly remain part of the group, which was disappointing. We expect the company's organic revenue growth to slow to 1% (4-6% in 2022-23), driven by a challenging market. We expect EBITA-% to be 12.6% in 2024 (2023: 12.6%). Q1 company report on Tietoevry is available here.  

Vincit’s revenue decreased by 17% to 23.0 MEUR in Q1 and was slightly below our forecast. The change was entirely organic, down sharply from -10% in Q4'23. In the big picture, the weak development is due to a difficult market environment and increased competition, especially in the customized software development, as well as the weak development in the US. EBITA weakened considerably year-on-year and amounted to 0.7 MEUR, or 3.0% of revenue, slightly above our expectations (Q1e 0.6 MEUR). The result was burdened by lower revenue, weak billing rates in the US (-0.2 MEUR or EBITA -12%) and project overruns (impact on EBITA of approximately 1 pp). The overall profitability level can be considered weak for the company, even though the decline in revenue resulted in a clear headwind. We forecast Vincit's revenue to decline by 8% to 91 MEUR and adjusted EBITA-% to rise to 4.6% in 2024, driven by cost savings and billing rates (2023: 3.4%). Q1 company update on Vincit is available here (in Finnish).

Witted’s Q1 report was largely in line with our expectations, although there was a negative surprise with the number of experts decreasing by 11 in March. Witted’s Q1 revenue decreased significantly by -18% to 14.8 MEUR (Q1'23: 18.2 MEUR), which was nevertheless in line with our expectations. Organically, revenue decreased by approximately 21%. The decline in revenue was due to the expiration of customer contracts, especially at the turn of the year, and to the fact that new sales have been slowing down for some time in a difficult market environment. Profitability continued its improving trend thanks to cost-saving measures and the adjusted EBITA-% of 2.6% was in line with our expectations, but excluding adjustments, profitability (EBITA-% of 0.7%) was slightly below our expectations. On the positive side, other operating expenses were lower than expected and the gross margin continued on an improved trend, according to our estimates. We now expect Witted's revenue to decline by -15% (-16% organically) to 55 MEUR in 2024. We expect the adjusted EBITA-% to rise to 2.6% in 2024, driven by cost savings and improved gross margins (2023: -0.3%). The Q1 company update on Witted is available here and our comment on the April revenue review here (in Finnish).