IT services sector 2024 expectations fell slightly in Q2, but H2 looks a little better

Translation: Original published in Finnish on 10/9/2024 at 7:20 am EEST.

With the Q2 reports and subsequent profit warnings, our revenue and profitability expectations have declined slightly. The expected strengthening of the general economic development in Finland and Europe and the interest rate cuts provide some light at the end of the tunnel and create the conditions for a gradually improving demand outlook also for the IT services sector next year. However, the timing and magnitude of the recovery in demand are difficult to estimate, which keeps uncertainty high. Our main concern in the sector is fierce price competition. We expect the second half to be slightly better than the first. As a result, we expect the sector's revenue to be flat year-on-year and profitability to improve slightly in 2024 driven by cost savings, but still below potential. We continue to note that there are large differences between companies. 

We expect the decline in revenue to moderate and profitability to improve in H2

The outlook for Nasdaq Helsinki's Q3'24 earnings season is weak as the economic situation in Finland and Europe in general remains subdued - “the recovery is still to come”, analyst Juha Kinnunen wrote in Inderes' Morning Review earlier this week. We expect IT services revenues to continue to decline slightly in H2, but at a slower rate than at the beginning of the year. As a result, the IT services sector is currently underperforming the average company on Nasdaq Helsinki, after years of outperforming the stock market average.

We expect the organic revenue decline (y/y) in the IT services sector to have slowed considerably from H1 (H2 average -0.5% vs. H1 -3.7%). However, the moderation of the decline is partly explained by the weaker comparative period in H2'24, when organic growth at sector level was still strong (10%), especially in Q1'23. We also expect H2 adjusted EBITA-% to improve versus H1. Some of the improvement is company-specific. Tietoevry's and Loihde's profitability is seasonally stronger in H2, Solteq's profitability is supported by the cost saving program implemented in Q2, and Vincit's profitability is supported by efficiency measures and the expected turnaround in revenue development.

Siili and Innofactor issued profit warnings in September. In addition, we believe that several companies remain at clear risk of guidance downgrades for the remainder of the year, albeit to varying degrees.

In 2024, we expect revenue to be at the level of the comparison period

In 2024, we expect the development of companies to remain broadly diversified based on their different profiles. We expect companies with a software development profile and a stronger private sector focus to continue to underperform on a relative basis this year (Siili, Vincit, Witted). However, the biggest drop since the first quarter has been in revenue forecasts for Gofore, which has led the sector for years, falling 4 percentage points. Gofore's strong public sector focus and the nature of its long-term contracts make it more post-cyclical than many of its peers. The situation is complicated by the fact that the company has sought to protect its profitability, which is well above the industry average, which is challenging in the current climate of fierce price competition. Other strong public sector players, such as Netum, Digia and Tietoevry, have been less affected. On the contrary, some of them have even accelerated their growth compared to previous years (Digia and Innofactor). The strong public sector players mentioned above also have other recurring or long-term contract revenue, as does Digital Workforce.

We expect organic growth in the IT services sector to be broadly in line with the comparison period. However, M&A activity has been record low in 2023, so acquisitions will not provide much growth support. In future quarters, comparison figures will be easier as Q1’23 was the last good comparison period. In addition, there will be further tailwinds from working days in Q3. We forecast the median development in revenue for the companies in our coverage to be -1.0% and the average +0.4% in 2024. We estimate the median and average of our closely monitored organic growth to be +0.0% and -1.4%, respectively. Thus, the organic growth forecast is practically unchanged. As a result, we expect organic growth to be significantly slower than in the 6 years to 2023 (2023: 0 % and 2018-2022: 8-16 %). The historical comparability of the mean and median is affected relatively clearly by the fact that Witted and Digital Workforce have changed their focus from growth to profitability in the last 1-2 years and that this transition journey is still ongoing.

There is still considerable uncertainty about the market situation and customer demand, although there is light at the end of the tunnel. The quarter-on-quarter decline in the number of employees slowed (to -1%) in Q2 compared to previous quarters (Q4’23: -4% and Q1’24: -2%). This gives some confidence that the bottom of demand is near.

Source: Inderes

Total headcount as reported by the companies. Gofore, Siili, Vincit and Witted calculated on the basis of the FTE reported by the companies. The number of employees at Loihde in Q1 is estimated based on the average of Q4 and Q2.

Interest rates (long-term rates and Euribor) have turned downward, driven by slowing inflation, but also partly by a more delayed recovery in the economic outlook for the eurozone. Interest rates are expected to fall further, with Euribor futures predicting that the 3-month Euribor will decline to around 1.8% next year from the current level of around 3.3%. The 12-month Euribor has already fallen significantly to around 2.8%. As the European economy improves next year, we see prospects for stronger demand over the next year. The need for digital investment remains as strong as ever, and clients have also put development projects on hold due to cost-cutting measures. In the short term, we believe that the development of demand in the sector will depend on the general economic situation and forecasting the industry will remain more challenging than usual.

In the talent market, turnover will remain low and the availability of talent is better than it has been in years. In other words, for those companies where sales are working, the conditions for growth are good. We anticipate that managing billing rates will continue to be challenging due to market sensitivities and changes. In addition, we expect customer pricing to remain under pressure in a highly competitive environment. In our view, price competition is currently the biggest risk in the sector. For many operators, pricing pressures have already deeply eroded order books, making the return to a more profitable growth path slower than previously expected. The longer the downward pressure on prices continues, the weaker the order book structure of the entire sector will become and the slower the turnaround will be.

We expect profitability to improve driven by cost savings

With the Q2 reports and subsequent profit warnings, we have slightly lowered our profitability expectations (0.7 percentage points) due to weaker-than-expected results and pricing pressure from customers. We expect the median EBITA margin of the companies in our coverage to decrease to 5.2% (2023: 7.1% and 2018-2022 7.6%), but the average to be 6.5%, improving clearly in 2024 (2023: 4.9%). Profitability challenges will continue to arise from the difficulty of managing billing rates, with projects on hold and growth under pressure. We expect wage inflation to be more moderate than in recent years, but fierce price competition makes the equation of wage inflation and customer prices negative for companies, putting pressure on profitability. An example of price pressure is Gofore, whose average customer prices fell by 1.0% in Q2'24 from +3.8% in Q1'23. However, the majority of Gofore's business is in the public sector on long-term contracts, which even slightly masks the true picture of price pressure as it has not yet fully penetrated the order book. Price competition is putting pressure on profitability in the IT services sector while wages do not show a similar elasticity (Gofore +0.1% Q2'24). 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. Several companies have adjusted their cost structures over the past year, leading to a slight improvement in profitability trends, although we expect profitability levels to remain below potential. If the market improves, we could see profitability levels return to much better levels, at least temporarily.

A comprehensive summary of the IT services sector and company-by-company comments on the Q2 results can be found here.