IT services sector Q3 summary: Better than feared with several areas continuing to perform well

Translation: Original comment published in Finnish on 11/21/2023 at 7:24 am EET.

Overall, the Q3 earnings season was stronger than our cautious expectations and the market continued to be mixed. Many areas are still performing well and in the weaker areas it seems that, at least temporarily, the bottom of demand has been touched. There are already some cautious comments on the better, but in our view it is still too early to draw larger and broader conclusions. Uncertainty remains high and could spread to new areas if the economic weakness persists beyond current projections.

In terms of reported figures, organic growth of Finnish listed IT services companies improved slightly in Q3 from a weak Q2. In contrast, profitability was clearly down year-on-year, yet above our cautious expectations. New change negotiations and profit warnings have continued to emerge over the fall and early winter, and savings should support profitability going forward. The growth of other Nordic companies in Q3 was also well above the average for Finnish listed companies and profitability was slightly better, which could indicate that the bottom is already behind.

Revenue development was still very mixed, but improved slightly from a weak Q2

In Q3, revenues in the Finnish IT services sector grew in line with our low expectations, in a difficult market environment. Organic revenue growth for the companies in our coverage was 2%, which is a slight improvement from a weak Q2 (0%), but well below the strong Q1 level of 10%. On average, the companies’ organic growth still 3% (Q1’23: 9% and Q2'23: 2%). The weaker development was again partly due (like in Q2) to one working day less than in the previous year, while Q1 had one working day more than in the previous year. Overall, revenues were in line with our expectations, with 1 above, 6 in line and 2 below our forecast. For companies with operations in Sweden and Norway, exchange rates also continued to create headwinds. We did not adjust the FX effect from the companies because a majority of the companies did not report it.

In the big picture, the third quarter continued the trend of Q2, i.e., the market was still very mixed. Companies with more recurring revenue (longer order books), deep and strategic customer relationships, that operate in the public sector, have long contracts, ERP business, and generally those who make business-critical solutions for customers clearly fared best in Q2-Q3. Companies with a high emphasis on the private sector and software development fared the weakest. The weakness of customized software development at Vincit, Siili Solutions, Witted and Loihde, among others, was clearly reflected in the development of revenue.

Demand uncertainty increased in the private sector in the summer of last year, which was initially felt selectively per company and customer sector (e.g. consumer products), but was not felt more broadly. Only in Q2'23 did the changed market situation start to be reflected more strongly, especially in customized software development and better availability of talent. The competition for customers was tight and, based on the comments of many companies, customer decision-making was very slow in the spring. Price competition was particularly evident in large public sector tenders, but also to some extent in the private sector.

To our understanding, the situation in terms of customer prices and volume declines stabilized in Q3, although still weak in the big picture. For companies operating with longer order books, the weak economic cycle will probably be realized in the figures later at least in part. By contrast, we believe the public sector is living its own cycle and 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 only beginning to grow. 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 are now seeing, albeit rapid in places, is just a normal cyclical feature of the economy and has hit only part of the market. There have been preliminary comments on the improving market for customized software development in the unlisted space, which was also reflected in Digia's Q3 results, but overall it is still too early to draw broader conclusions. For the moment, however, it seems that the bottom of demand may have been found. 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. 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 strong.

Much 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. However, with the higher interest rate environment, it is also reasonable to assume that the required 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.

Several areas continue to perform well. In this market situation, projects that are business-critical (such as data and analytics and 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. However, we suspect that it is difficult for IT service companies in the big picture to stand out from each other competitively.

In a rapidly changing market situation, many companies have had to carry out change negotiations, even more than one. The change negotiations have concerned both non-billable roles and billable roles. If uncertainty in customer demand persists for longer, it is very likely that new efficiency needs will emerge in the sector.

Source: Inderes and the companies

Full effect of cost savings yet to be felt in Q3; profitability declined but beat our low expectations

The median adjusted EBIT margin for the sector was 6.3% in Q3, down relatively clearly year-on-year (Q3'22: 8.7%). Last year, companies' demand and profitability were still at a good level across the sector, although there was more talk of uncertainty. On average, profitability decreased less and stood at 5.2% (Q3'22: 6.0%). Overall, profitability levels were quite well above our low expectations, with 4 in line and 5 above our forecast. Profitability continued to be under pressure from fierce price competition and falling volumes, especially in the customized software development market, wage increases based on collective agreements in the spring and general inflationary pressure. In addition, one less working day compared to the previous year put pressure on profitability. Many companies responded to the more difficult market conditions with change negotiations and efficiency measures that supported profitability only slightly in Q3. These will support Q4 to some extent but have a stronger effect only in early 2024. If the weakness in demand spreads to new areas of expertise and/or customer sectors, new change negotiations are likely.

Source: Inderes

The sector's profitability is now well below recent levels (just under 9%), at 5-6%. Now that companies are also focusing more on cost structures as the economy and demand recover, we may see profitability return to much better levels, at least temporarily.

Source: Companies and Inderes

However, we think it is relevant for investors to think about what the demand situation will look like in a year's time, rather than getting too locked into the short-term outlook. Stock markets are likely to react to improving market conditions even before they start to show up in company figures. This has happened in previous crises, and share prices tend to rise quickly from bottom levels. We will publish our expectations for the IT services sector in 2024 in the near future.

Nordic companies fared better also in Q3

We included 12 (2 new) Nordic listed IT service companies in the review operating in the same service areas as the Finnish companies in our coverage. For other Nordic companies, median growth was 9% and organic growth 8% (Q2'23: 14% and 7% respectively). In relative terms, organic growth in the other Nordic countries was thus still clearly better than that of Finnish companies.

The median EBITA margin for other Nordic companies (excl. Finnish companies) was 6.6%, only slightly better than that of Finnish companies (6.3%). Profitability improved from a weak 4.9% a year ago. The profitability development was supported by the cost savings already implemented and higher billing rates.

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. However, comments suggest that the market seems to have stabilized, albeit at lower levels than in the past. Cost-efficiency measures are being implemented, AI is the hot topic and projects are starting to move back into implementation.

Brief company-specific Q3 comments

Digia's Q3 revenue grew 7% year-on-year (organic 6%), which is particularly good given the weakened demand environment in the IT services market (sector Q3: +2%). Digia comments that customized software development grew well in Q3, which is surprising as this is the area that we understand has slowed the most in the IT services market. The company still has projects on hold and talent on the bench waiting to get to work, which slows growth and affects billing rates. EBITA was 8.3% of revenue and decreased year-on-year (Q3’22: adj. 8.7%) and below our expectations (9.2%). Between 2024 and 2025, we forecast organic revenue growth of 2% and 5%, with profitability gradually rising to just under 10% in 2025, supported by earlier investments. The Q3 company report on Digia can be read here and the just published full company report here (both in Finnish)..

Gofore’s Q3 revenue increased by 29% to EUR 40.8 million, of which 20 percentage points were organic, clearly outpacing the overall market growth (Q3: 2%). In its comments, the company was cautious about the near-term outlook for the private sector, although it has not yet seen a significant slowdown in investment among its client base. However, the company expects a fierce competitive situation and price competition to continue next year. Gofore's adjusted EBITA margin was 11.6%, which is still a fairly good level for a seasonally weaker quarter and excellent in the context of the sector. The improved profitability was driven in particular by an increase in the billing rate, which improved towards the end of the quarter. In addition, the relationship between the development of customer prices and wages was positive, which is particularly positive in a market of increased price competition. We now forecast organic growth of 8% in 2024, outperforming the market. We expect growth next year to be held back in particular by weaker demand in the private sector and lower prices in the public sector. The Q3 company update on Gofore is available here and a comment on October figures here (both in Finnish).

Innofactor's Q3 revenue grew by 8% and the growth was entirely organic. The growth can be considered particularly good in a challenging market where the sector's growth has been clearly weaker (sector Q2: 0% and Q3: +2%). Organic growth was driven by increasing subcontracting, recruitment and, we believe, a small increase in billable utilization. Q1 comparable EBITDA increased to EUR 2.0 million, which clearly exceeded our EUR 1.4 million estimate and accounted for 10.9% of net sales. We estimate that profitability was at a very good level in Finland at around 20% and in the red in other countries. We expect revenue to grow organically by ~3% in the coming years, driven by billing rates, and the EBITDA margin to be around 11%, limited by wage inflation and use of subcontracting. Q3 company update on Innofactor is available here.

Loihde Group's Q3 report missed our expectations in terms of revenue (+1%), but beat our forecasts in terms of profit and especially profitability (adj. EBIT-%: 3.4%, Inderes: +1.9%). Contrary to our expectations, security business revenues turned into an organic decline (estimated at -4%) and digital development also continued its expected sluggish development (organic decline estimated at 8-9%) in a difficult market environment. The one-off/ temporary challenges that weighed on profitability in the early part of the year (especially ERP problems, low invoicing rates in digital development) seemed to have largely disappeared. In digital development, the market for customized software development, one of the company's key areas, is still very difficult and there is no sign of relief, but in data & analytics the outlook has improved since the beginning of the year and cloud consulting is still performing well. As expected, Loihde issued a negative profit warning after Q3, but the warning was bigger than we had estimated (Inderes' adjusted EBITDA forecast was 9.5 MEUR vs. the new guidance midpoint of 8 MEUR). In 2024, we forecast revenue to decline organically by 1% and EBITA margin to rise to 3.5% of revenue. The Q3 company report on Loihde can be read here and the profit warning update here. The company also recently held a CMD, which can be viewed here (all in Finnish).

Siili Solutions’ revenue was flat year-on-year and in line with our expectations. In organic terms, revenue fell by 4%, as the weakness of the market hit Siili Solutions’ key areas. The market weakness has hit the areas of expertise that are important to Siili Solutions, especially software development and the automotive sector. We understand that demand in the financial sector and the public sector has been relatively better. EBITA decreased year-on-year and was 4.7% of revenue in Q3 (Q3'22: 8.7%). According to our estimates, profitability was weighed down by lower billing rates as organic growth declined. In early October, the company announced new change negotiations to support Q4. In 2024, we forecast revenue to decline by 1% and EBITA margin to increase by 0.5 percentage points to 7.2% of revenue. The Q3 company update on Siili is available here (in Finnish).

Solteq's Q3 revenue decreased by 15%, which was below our expectations. On a like-for-like basis, revenue turned again to growth of 2%, driven by Retail & Commerce. The Utilities segment's revenue was flat, when we expected the segment to have already started to grow. Comparable EBIT was -6% of revenue. The result was weighed down by the weakness of the Utilities segment (EBIT -35%), but this will be more strongly supported by the company's substantial cost savings of EUR 3.8 million from next year onwards. The bright spot of the report was Retail & Commerce's comparable EBIT, which rose to 4%, above our forecast of 1%. We forecast organic revenue growth of 2% and an adjusted EBIT margin of 5.2% in 2024. Q3 company update on Solteq is available here (in Finnish).

Tietoevry’s revenue decreased by 4% in Q3, and organic revenue growth slowed to 2%. Although organic growth slowed well below the strong level of the previous 12 months (7% on average), we believe that achieving organic growth was a respectable performance given the difficult market conditions. Tietoevry's EBITA margin was 13.0% in Q3, slightly below our and the market's forecasts. Demand fundamentals for Tietoevry and the IT services sector are foggy in the short term, but strong in the medium and long term. In 2024-25, we forecast growth to continue at 3% and profitability to gradually increase to 13.3%. Our forecasts are well below the company’s targets (growth of 8-10% and EBITA of 15-16% by 2025), reflecting the current challenging market environment. Q3 company update on Tietoevry is available here.

Vincit's revenue decreased by 4% in Q3 and was entirely organic. Thus, the rate slowed down from Q2’23 (-7%). In the big picture, the weak development was still due to a difficult market environment and increased competition, especially in the customized software development sector. EBITA was 6.3% of revenue in Q3 and well above our forecast of 2.2%. Profitability was supported by cost savings of EUR 3 million at the beginning of 2023 and continued efficiency measures in Q2. As the market continued to be weak, the company announced in October new change negotiations aimed at achieving further cost savings of EUR 3 million. To improve competitiveness, Vincit is also planning new tasks. In 2024, we forecast revenue to be at the 2023 level and EBITA margin to rise to 6.8%, driven by the EUR 3 million cost savings program. Q3 company update on Tietoevry is available here (in Finnish).

Witted's revenue grew strongly by 23%, driven by acquisitions. In organic terms, revenue contracted by -1.5%, but we estimate that the weakening of exchange rates had a negative impact of around 3 percentage points on revenue. Profitability (adj. EBITA -2.0% vs. Inderes -0.9%) was almost in line with our expectations, but still remained weak in international operations, which led the company to initiate further savings measures. However, the cost-saving measures taken by the company in Q3 and early in the year should be positively reflected in profitability for the rest of the year. The bright spot of the report was the good organic growth in international net sales adjusted for FX (Inderes estimate >20%). We estimate that the decline was partly due to the change negotiations and to a larger extent to fewer project starts. In 2024, we forecast revenue to fall by 2% in organic temrs and EBITA to rise to 2.5%, driven by cost savings and improved sales margins. The Q3 company update on Witted can be found here (in Finnish).