IT service sector valuation levels at the bottom of our 7-year monitoring history, justifiably?

Translation: Original comment published in Finnish on 1/18/2024 at 7:16 am EET

We examined the development of valuation levels in the IT service sector through the forward-looking EV/S ratio in 2017-2024. The valuation levels have hit the bottom of the review period. The uncertain short-term outlook and the rise in interest rates partly justify a lower valuation, but we feel the sector’s expected return is at an attractive level as a whole. However, in the current market turmoil, we estimate that company-specific differences will increase, which highlights the importance of stock picking.

In this article, we focus on the EV/S-based valuation and seek reasons for the lowest valuation levels in history from current market drivers. We will also examine the biggest sector trends. Later, we will look at the development of earnings-based valuation as well.

EV/S is a good valuation thermometer for expert companies

The balance sheets of expert companies are typically very light, as organic growth practically ties no capital to the balance sheet. In the short term, there may be room for improvement in billing rates, which enables companies to grow, but in the long run, volume growth is based on recruiting new employees. Thus, growth investments are directly reflected as expenses in the income statement, mainly as investments in recruitment, sales and administrative structures. As a result, the more stable balance sheet based valuation does not provide much support for expert companies.

By contrast, sales-based valuation can provide a stabler indicator for expert companies' valuation. The market tends to over and underestimate the growth and profitability outlook in the short term, so the sales-based valuation provides the investor with a chance to gage possible under and overvaluations in the sector. Roughly it could be said that if the growth and profitability outlook of the sector and the market's required return remain stable, the sales-based valuation should also remain stable. For example, in 2020-2022 the median EV/S ratio for the next 12 months of the IT service companies we examined hit a clearly higher level than the historical levels for a prolonged period which proved unsustainable. However, especially for an individual company, simply focusing on the sales ratio is not the answer since the sales ratio must also be proportional to the company's growth, profitability and risk profile. Historically, profitability has been a more dominant variable than growth in terms of valuation. On the other hand, the returns of the best investment objects in the sector have been based on strong growth (especially organic, e.g. Gofore).

Source: Inderes

Sales-based valuation is very low relative to history

The graph above shows that the median EV/S for the next 12 months of the sector over the entire reference period was 0.89x. Currently, the valuation has fallen to the bottom of the examined period at 0.67x. At the end of 2018, EV/S was also at a low level of 0.76x, when the IT service sector followed the market in a fast stock market crash. Prior to COVID, in 2017-2019, the valuation level was roughly at 0.8x-1.0x. Financing conditions have tightened and interest rates have risen clearly since then, which means that the increased required return in itself explains a somewhat lower valuation level. The lower valuation is also partly explained by the overall uncertain market situation and the subdued short-term outlook. We will discuss the possible drivers of the lower valuation later in this article.

We have included four new companies over the past few years in our research portfolio, which partly affects the comparability of the examination. However, as we can seen from the graph below, the exclusion of these companies does not substantially change the overall picture.

Source: Inderes

The hot sentiment of the COVID years caused valuation levels to gallop

In the early stages of the COVID virus, new sales of IT service companies hit a wall as customer companies’ decision-making became paralyzed. However, demand recovered very quickly as COVID pushed customers and employees more to digital channels, which, in turn, increased demand for IT service companies. In addition, the negative effects of COVID were very sector-specific (e.g. restaurant and tourism) overall, and private consumption actually turned very strong after the initial shock.

Central banks' stimulus reached record levels and interest rates remained firmly negative, which was reflected as low required returns and high liquidity on the stock exchange. As a result, and relished with a heated sentiment, the valuation level of the entire stock exchange rose clearly, but especially the prices of growth companies skyrocketed. As the graph shows, the sector's median EV/S for the next 12 months rose to 1.6x in Q2'21. The growth and profitability of the group of companies rose to strong levels, but the valuation levels did not prove sustainable.

There are reasons for the low valuation levels, but now a gloomy scenario is being priced

Many of the companies we monitor have grown very rapidly in the 2010s and 2020s. The driving force behind this has, above all, been the digitalization of society. Based on current valuations, the growth and profitability conditions of the sector seem to have clearly weakened from earlier. We see four clear drivers that could justify weaker growth and profitability conditions in the future. Normal cyclicality in the economy, rising interest rates (higher required returns for investment), potential disruption of AI and market transformation as the digital maturity of customer companies increases.

AI will certainly change the industry significantly in the long term and already in the short term through increased productivity. At the same time, it will create a lot of new business opportunities in the IT service sector for companies that are able to jump on this bandwagon. For example, the advent of AI already clearly supports the demand for data expertise, as actual utilization requires a lot of work in the data interface.

The short-term outlook (2024) is still very uncertain as Finland’s economic outlook is sluggish and development budgets are tighter than before. Companies' digital development investments focus more on maintaining and repairing existing systems and services and efficiency. Companies are clearly more cautious when it comes to new development projects. On the positive side, interest rate and inflation expectations have decreased, and 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 and the share prices of many global export companies have developed strongly over the past year (e.g. Wärtsilä, Konecranes, Cargotec, the DAX index), which typically indicates a turn for the better also in the real economy. In the public sector, price competition has remained fierce and the government’s austerity measures can reduce budgets, but so far, a lot of projects have also started. Especially social and healthcare services support demand. Overall, the more subdued short-term outlook also justifies lower valuation levels in the short term.

The strong growth of the brightest stars in the sector before the weaker market situation was also supported by their ability to recruit experienced experts in the tight talent market. Now, at least in the short term, when experts are better available, customer companies can more easily recruit more experienced employees in-house. At the same time, the digital maturity of companies has increased and digital services have become the focus of value creation for more companies. Many roles where consultants have been used have turned into permanent development roles, making in-house recruitment sensible. Companies that have carried out large recruitments, some of which we estimate have been made to replace consultants, include OP, Kesko and S Group. This partly reduces the size of the IT service market/slows down growth at least in some service areas. It is good to note the effects of this trend when considering company-specific differences. However, there are still many sectors and companies whose digital maturity is not at the level of the above-mentioned companies. It is also highly possible that, as the market cycle warms up, consultants’ edge in recruitment compared to customer companies will improve again, as experienced employees want to develop, be better compensated and work with the latest technologies.

Overall, in light of current information, we believe it is premature to declare that the industry has rapidly deteriorated significantly over the longer term, even though the outlook is clearly more blurred than it was, for example, 3 years ago. This is, of course, also a traditional manifestation of a more difficult economic situation. Typically, the best places to buy are when the news are still darkest. In terms of valuations, the current situation seems like a textbook example of an overshoot on the stock exchange, as bad times are extrapolated to continue far into the future.

Even in a changing market situation there are always winners, the importance of stock picking is emphasized

In a changing market situation, we believe the winners are the companies capable of continuous change, who find new growth pockets in new service areas and are able to prove value creation to the customer (strong customer relationships and most talented experts). Recruiting skills will also always remain important. The best high-tech consultants probably look very different in terms of their service areas than, for example, 5 or 10 years ago. It is also worth noting that many of the companies we monitor have grown much faster than the market. Market growth will certainly help companies, but ultimately the growth and profitability development will depend much more on the company itself. Due to the trends and factors discussed above, we believe that the differences between companies will become more pronounced, which also emphasizes the importance of stock picking.

Company-specific valuations have moved in tandem, but there are differences

The graphs below show the company-specific forward-looking EV/S ratios over time and company-specific medians. The valuation levels have largely moved in the same direction. Of the companies that have been on the list longer and for which more data is available, especially Tietoevry, Vincit, Gofore and Digia stand out. Tietoevry stands out with its stability. Tietoevry was also practically the only company whose valuation was not clearly boosted during COVID. Vincit stands out because of its clearly declining valuation level, which derives in particular from the decreased profitability level but also from slower organic growth. Gofore, on the other hand, stands out because of its higher valuation. Historically, high levels have been earned thanks to the company’s very strong profitable growth. Digia is the only one whose valuation level has risen from pre-COVID levels. This is especially caused by the company’s stable and strengthened profitability development.

Source: Inderes