Q4 IT service sector summary: Growth and profitability in line with our expectations, 2023 can be seen as a defensive win

Translation: Original comment published in Finnish on 03/20/2024 at 7:20 am EET.

Overall, the Q4 results were exceptionally well in line with our expectations. Organic growth of the Finnish listed IT services companies was in line with the comparison period and slightly weaker than in Q3. Full effect of cost savings yet to be felt in Q4; profitability declined in line with our expectations. The growth of other Nordic companies in Q4 was also slightly above the average for Finnish listed companies, and profitability was at the same level. For 2023 as a whole, revenue increased slightly on average and profitability was close to the level of the comparison period, which can be seen as a defensive victory given the economic situation. In general, the overall difficult economic situation continues to dampen customer demand and cause various symptoms in the sector, including pressure on customer prices.

As expected, organic revenue growth fell to zero, but the development was very mixed

In Q4, revenues in the Finnish IT services sector developed in line with our low expectations in a difficult market environment. The organic revenue growth of the companies in our coverage remained at zero, a slight deterioration from Q3 (2%). The weaker performance was again (as in Q2 and Q3) partly due to one working day less than in the previous year (an impact of just under 2%). Overall, revenues were exceptionally well in line with our expectations, with 1 company above, 9 in line with and 1 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 (with the exception of Tietoevry) because a majority of the companies did not report it.

Source: Inderes

In the big picture, the fourth quarter continued the trend of Q2-Q3, i.e. the differences between the companies were again large. Netum grew organically by up to 18% (H2) and several companies saw their revenue decline by almost 10%. As the market situation became more challenging, companies with more recurring revenue (longer order books), deep and strategic customer relationships, that operate in the public sector, have long contracts, have ERP business, and generally those who make business-critical solutions for customers have fared best in Q4. 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, and Witted, among others, was clearly reflected in the development of revenue.

In Q2'23, the uncertainty in demand was more pronounced across our tracking, especially in customized software development and better availability of talent. Price competition was particularly evident in large public sector tenders, but also to some extent in the private sector. In Q4, price competition has continued to be fierce again and several companies that had previously said they would stay out of price competition have now partly joined in, putting pressure on margins in the sector.

In terms of market dynamics, it can still be said that for the first time in many years, competition clearly shifted from talent to customers last year. 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 is good. 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.

Source: Inderes

Full effect of cost savings yet to be felt in Q4; profitability declined in line with our expectations

The median adjusted EBIT margin for the sector was 7.7% in Q4, down 1 percentage point year-on-year. In 2022, companies' demand and profitability were still at a good level across the sector, although there was more talk of uncertainty. On average, profitability declined slightly more and stood at 5.8% (Q4'22: 7.2%). As a whole, profitability levels were relatively well in line with our expectations, with 5 companies in line (within 1 percentage point), 3 above and 3 below our forecast. Profitability remained under pressure from fierce price competition, falling demand, and 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 already in Q2-Q3, but the impact on profitability was only partly felt in Q4 and more strongly in early 2024. 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%) slightly 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

2023 can be seen as a defensive win overall

In 2023 as a whole, organic revenue development was 0%, which is the worst year in our monitoring history (2018-2022: 8-16%). Performance was weighed down by the general economic slowdown and its impact on customer demand. In addition, there were two fewer working days in 2023 compared to the previous year, which impacted revenue by just under 1% and profit through a leverage effect. Acquisitions continued to be a key driver of growth last year, contributing on average around 6 percentage points to the development. The M&A transaction market slowed down significantly last year, and so there is unlikely to be anywhere near the similar pull in 2024. The median adjusted EBITA-% was 6.9%, slightly lower than last year (7.1% in 2022), while the average fell more sharply to 4.9% (6.9% in 2022). Profitability, in particular, can be seen as a defensive win, as billing rates, wage inflation, and weak customer price development created significant pressure in this area.

This duality was also reflected on an annual basis, with the organic revenue development ranging from -7% to +22%. The adjusted EBITA-% ranged from -7% to +14%. The drivers of this duality are very much the same as those described above in the Q4 section.

In a rapidly changing market situation, many companies had to carry out change negotiations and some even more than once. The change negotiations involved both non-billable roles and billable roles. If the uncertainty in customer demand persists for longer, it is likely that new efficiency needs will emerge in the sector, as they already have in 2024.

Source: Inderes

Nordic companies fared only slightly better in Q4

We have included 12 Nordic listed IT service companies in the review operating in the same service areas as the Finnish companies we monitor. For other Nordic companies, median growth was 6% and organic growth 2% (Q3'23: 9% and 8% respectively). The organic growth in the other Nordic countries was thus still better than that of Finnish companies, but the gap narrowed from the 6 percentage points in Q3.

The median EBITA margin for other Nordic companies (excl. Finnish companies) was 8.0%, only slightly better than that of Finnish companies (7.7%). Profitability was at the level of the comparison period, whereas in Q3 it had improved from the comparison period.

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. 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.

Brief company-specific Q4 comments

Digia's Q4 revenue increased by 9% from the comparison period to 53 MEUR, in line with our expectations. Organic growth slowed down compared to previous quarters and was moderate (3%), given the challenging IT service market. The company commented that the market was good in October and November, challenging in late December, but better again in January. EBITA was 9.6% of revenue, slightly below expectations. However, profitability improved from the previous 6 months, driven by billing rates, according to our estimates. We forecast revenue growth of 6% in 2024, driven by acquisitions (4%) and supported by organic growth. We expect EBITA to increase by 12% to 21 MEUR, driven by revenue growth and profitability. The profitability improvement will be driven by higher billing rates. Digia’s Q4 company update can be found here (in Finnish).

Digital Workforce’s H2 revenue decreased by 9% to 12.3 MEUR and exceeded our forecast slightly. The strategically important continuous services, which account for good 60% of revenue, decreased by 3% (forecast -4%). Expert services decreased by -17% (forecast -25%). The decrease in revenue was affected by the departure of one customer early in the year, delays in project starts and challenges of new sales, which largely stem from the market situation. In H2, Digital Workforce’s adjusted EBITDA decreased by 9% to -0.2 MEUR and was slightly below our forecast. EBITDA-% (adj.) was thus -1%. We expect that the company’s revenue will grow by 3% and EBITDA will be 0.7 MEUR or 3% of revenue in 2024 (2023 adjust. EBITDA 0.2 MEUR). The forecasts include a relatively strong trend change from H2’23 (revenue -9% and adj. EBITDA-% -2%). The H2 company update on Digital Workforce is available here.

Gofore’s revenue was already known for Q4 and increased by 13% to 52 MEUR. Organic growth accounted for 9 percentage points of the increase. Geographically, international revenue grew 19% and organically, we calculate that it grew 5%, which is significantly slower than in previous quarters. The company managed to keep customer price developments and wage inflation relatively well balanced. Gofore's adjusted EBITA increased by 10% to 8.3 MEUR and amounted to 16.0% of revenue, which was well above our forecast of and more than double the industry average. Gofore once again demonstrated its excellence in managing billing rates. Based on Gofore's comments, there is still room for improvement in billing rates compared to Q4, which also reflects a structurally efficient organization and up to 20% EBITA margin potential in individual quarters. After the February figures, we slightly updated our forecasts. We now forecast organic growth to be 2% and EBITA-% to fall to 13.2% in 2024 (2023 14.1%), driven by rising depreciation and billing rates. The Q4 company update on Gofore is available here and a comment on February figures here (in Finnish).

Innofactor’s Q4 revenue grew by 7% to 21.9 MEUR, which was slightly above our forecast. Growth was entirely organic and the momentum was particularly positive in the current challenging market conditions (sector Q2-Q3 0-2 %). Organic growth was driven by higher billing rates, growth in the software business, and a small increase in subcontracting. Q4 comparable EBITDA increased to 2.9 MEUR, above our forecast of and representing 13.1% of revenue (forecast 11.3%). The earnings beat was driven by growth in the high margin software business and better-than-expected billing rates, as headcount declined against expectations and revenue slightly exceeded expectations. Geographically, EBITDA was positive in Finland but negative in other countries due to the challenging market situation. Thus, profitability was at a really good level in Finland, we estimate around 20%. We expect revenue to grow organically by 4-5% in the coming years and the EBITDA margin to reach around 12%, driven by billing rates and high-margin SaaS business. Q4 company update on Innofactor is available here.

Loihde Group’s Q4 figures were fairly in line with our expectations. We estimate that digital development contracted organically by around 4%, while the security business remained at around the previous year's level in organic terms. The overall outlook for the security business is stable, while the digital development will continue to face challenging market conditions. However, the Q4 result was below our forecast, mainly due to a write-down related to a customer receivable. Adjusted EBITA-% (excluding the write-down of a customer receivable) in the security business improved from last year to 5.3% (4.6%) in the seasonally strong final quarter. The improvement from the comparison period was particularly driven by better billing rates in digital development and the company’s measures to improve the efficiency of the organization. Loihde’s guidance is that in 2024, revenue will be on a par with the previous year or grow and adjusted EBITDA will improve compared to 2023. The revenue guidance was slightly stronger than we had forecast and the earnings guidance was conservative, as expected in an uncertain market situation. We expect Loihde's revenue to be at the previous year's level of 133 MEUR in 2024 (0% organic growth). We forecast adjusted EBITA-% to increase to 3.4% 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 Q4 company update on Loihde is available here (in Finnish).

Netum’s revenue increased by 46% to 20 MEUR in H2, driven by the acquisition of Buutti. Organic growth accelerated to 18%, which is a strong performance considering the challenging market situation (H1: 6%). Comparable EBITA was 1.5 MEUR or 7.7% in H2, which is a satisfactory performance in the sector context, but well below our expectations before the profit warning. In 2024, we expect revenue to grow by 24% to 46 MEUR, driven by the acquisition of Buutti (17 pp). We expect organic growth to remain good in the sector context (7%), but lower than in H2'23 (17%). In addition, we expect EBITA-% to rise to 9.4% in 2024 (2023: 7.4%), supported by cost savings and billing rates. The H2 report on Netum is available here (in Finnish).

Siili’s Q4 revenue decreased by 7% to 30.4 MEUR, which was slightly below our expectations. The market weakness has hit the areas of expertise that are important to Siili Solutions, especially software development and the automotive sector. Geographically, according to our calculations, international revenue growth turned into a 4% decline in Q4 (Q3'23 estimate +6%). In Finland, we estimate that revenue declined organically by 8% in Q4 and Q3. Adjusted EBITA decreased slightly year-on-year and was 2.5 MEUR, or 8.1% of revenue in Q4 (Q4'22 8.7 %). The result was slightly above our forecast and can be seen as a defensive win. According to our estimates, profitability was weighed down by lower billing rates (despite adjustments) due to weaker organic growth, wage inflation, and increased price competition. Profitability was supported by the two change negotiations and other efficiency measures implemented in H2. In 2024, we forecast revenue to decline by 1% to 122 MEUR, due to uncertainty in customer demand and a strong comparison period in Q1. We forecast adjusted EBIT to increase slightly to 9.0 MEUR, or 7.4% of revenue. Profitability will be impacted by the general increase in cost levels, which cannot be passed on to customer prices, and will be supported by the efficiency measures taken in 2023. The Q4 company update on Siili is available here (in Finnish).

Solteq’s comparable Q4 revenue of 14.2 MEUR was at the level of the comparison period and also in line with our expectations. Both segments developed as expected. Comparable EBIT was -1.0 MEUR, or -7% of revenue, slightly below our forecast. We are monitoring the development of cash flow and net debt particularly closely, due to the needs to refinance a bond this fall. Cash flow should improve significantly in 2024, driven by savings measures (3.8 MEUR), in order to make the refinancing less painful. We expect revenue to grow organically by 2% and EBIT to reach 2.9 MEUR, or 5.2% of revenue, driven by cost savings and billing rates. Q4 company update on Solteq is available here (in Finnish).

Tietoevry's Q4 revenue decreased by 2% to 752 MEUR, which was in line with our and consensus expectations. Organically, revenue increased by 1% (Q1: 8%, Q2: 3% and Q3: 2%). Adjusted EBITA was 108 MEUR in Q4, or 14.4% of Q4 revenue, which was in line with expectations. The result was still limited by inflation and supported by efficiency measures as staff numbers adapted to lower demand. We expect that the company’s organic revenue growth will slow down to 1% driven by a challenging market, which is below the 2022-23 levels of 4-6%. We expect EBITA-% to be 12.5% in 2024 (2023: 12.6%). Profitability is supported by a better revenue distribution and a lower expert turn Profitability is limited by wage inflation (4-5%), which is challenging to include in customer prices. Strategic assessment of operations is progressing and demergers will take place in the summer and/or later, which are clear drivers for dissolving the undervaluation. Q4 company update on Tietoevry is available here.

Vincit’s revenue decreased organically by 10% to 23.6 MEUR in Q4 and was slightly below our forecast. The decline accelerated from -5% in Q3'23. Geographically, the decline in revenue was led by the US (just under 20%), while revenue in Europe fell by just over 10%. In the big picture, the weak development is due to a difficult market environment and increased competition, especially in the customized software development in Europe. The challenges in the US are more internal from our perspective. Adjusted EBITA in Q4 was -0.1 MEUR, or ~-0.3% of revenue, and slightly below our forecast of 0.1 MEUR. Profitability thus decreased from 6% in Q3, reflecting the challenges in Q4. The result of the service business was burdened by weak billing rates in the US (-0.2 MEUR or -10% EBITA). We forecast Vincit's revenue to decline by 4% to 94 MEUR in 2024. We also expect the adjusted EBITA-% to rise to 4.6% in 2024, driven by cost savings and billing rates (2023: 3.4%). Q4 company update on Vincit is available here (in Finnish).

Overall, Witted’s Q4 report was relatively in line with our expectations. Revenue declined organically by 9% in a difficult operating environment, slightly more than we expected, while adjusted EBITA turned slightly more positive than expected at 2.7% after the beginning of the year, (Q4’22: 1.9%), driven by cost-saving measures and, we estimate, better gross margins. The turnaround is clearly visible compared to Q1-Q3'23 (adj. EBITA -1.2%). The company stopped providing guidance and will instead issue monthly reports, so there was no specific new information on the outlook. The company expects the market conditions to remain challenging in 2024. Witted also released a strategy update that shifts the focus to profitability in the coming years, putting growth on the back burner for the time being. In 2024-2025, Witted aims to achieve an adjusted EBITA-% of more than 8% in Finland and a positive adjusted EBITA-% in other countries. We have updated our forecasts after the company's monthly reports for January and February. We now expect Witted's revenue to decline by -12% (-13% organically) to 57 MEUR in 2024. We expect the adjusted EBITA-% to rise to 2.6% in 2024, driven by cost savings and improved gross margins (2023: -0.2%). Q4 company update on Witted is available here and at these links (January and February) (all in Finnish).