IT service sector: Bottom of cycle passed, grain will be separated from chaff in 2025

Translation: Original published in Finnish on 11/20/2024 at 7:19 am EET.

We expect a modest recovery in the IT services sector next year, driven by an improving overall economic outlook. We expect profitability to continue its upward trend from a weak level, but we also expect intra-sector spread to remain wide. In the coming year, companies should be able to see who has adapted to the changing market situation and whose strategy is working. In the short term, we expect the competitive situation to remain tight, but the expected gradual strengthening of the general economic development in Finland and Europe and lower interest rates will, in our opinion, create the conditions for a gradual improvement in the demand outlook next year. 

At market level, general economic development is a major determinant, but differences between companies are more pronounced

At the market level, we see the general economic situation as the most important driver for IT services companies. As long as customer budgets are on the decline and profit performance is weak, it is difficult to see a clear market-wide recovery in demand for IT service providers. However, investors should be aware that there are significant differences between companies in the IT services sector, which has been highlighted in this cycle.

In both Europe and Finland, expectations for GDP growth (2025) have moderated over time. The Bank of Finland now expects GDP growth of 1.1% in 2025, down from 1.7% in March. The eurozone GDP growth forecast for 2025 has been lowered to 1.3% from 1.5% at the beginning of the year. A clear factor supporting the Finnish economy is the fall in interest rates. The 12-month Euribor has fallen sharply from a peak of over 4% to around 2.4%. Inflation fears have resurfaced, particularly in the US following Trump's election, but interest rates are expected to continue to fall in Europe. Nevertheless, economic growth is expected to continue to pick up next year, which is obviously positive for the IT services sector, but we remain cautious in our forecasts for the time being. Typically, economic forecasts are overly optimistic until they become overly pessimistic after a turning point.

Companies in Inderes’ coverage.

The 2025 earnings forecast for Nasdaq Helsinki as a whole (Inderes’ coverage adj.  EBIT median) has clearly declined over the past year (around -10%), as the expected pick-up in the economic outlook has not materialized. However, as a preliminary positive driver, the Helsinki Stock Exchange has turned positive this year. While much of the stock market's earnings growth this year has been driven by cost-cutting measures, specific industries and global companies, the turnaround in earnings is a positive for IT services companies that live and die by their customers' IT budgets

Predicting the sector's performance around the current inflection point remains very difficult. We expect fierce competition from overcapacity to continue next year. The end of the year will tell us a lot about customers' savings needs, as projects traditionally end and new ones begin. In the private sector, we see that the toughest cuts have already been made on the customer front at the overall market level. However, there is still a need for savings as the economic outlook remains relatively weak, and unexpected savings needs may hit individual companies even harder. We believe a key trend in the coming year will be the continued centralization of private sector IT providers. Long-term strategic partners, companies with industry expertise, strong critical capabilities, and companies with a broad range of services are strong. So far, it seems that, in the light of the figures, Gofore and Digia have been the winners in this trend. Companies overall have commented on a pick-up in sales activity toward the end of 2024, and more have begun hiring again, suggesting that the bottom of the cycle is approaching or even passed.

Austerity measures in the public sector are upsetting the entire market demand forecasting deck. In the public sector, the need to evolve IT systems in the coming years remains evident and will continue to drive operational efficiency. At the same time, the need for savings is clear. This equation makes it difficult to predict what will happen. We expect the public sector as a whole to be sluggish compared to previous years, and continued pricing pressure is likely to make operating in this sector challenging. We believe that companies that do well in the public sector have the potential to continue to do good business there, although growth is likely to be more constrained. A key variable in the attractiveness of the public sector is private sector demand, as overcapacity drives price competition in large public sector tenders. Selling at a low price is often a better option for the company than doing nothing, at least in the short term.

In the coming years, the ability of companies to continuously innovate, which we often highlight, will be key as many companies are in the midst of change processes and seek to position themselves in highly attractive service, market and customer sectors. 

We expect revenue development to turn positive during the year

Our expectations for 2025 have fallen sharply over the past year as the turnaround in the broader economy has been postponed. In 2025, we expect the sector to return to moderate growth, but there is a lot of variation in the mix of companies. We forecast median revenue growth of +2.5% and average growth of +3.3% in 2025 for the IT services companies we monitor. We estimate the median and average of our closely monitored organic growth to be +2.5% and +2.3%, respectively. The M&A front has been record quiet, so inorganic support for growth remains low given the current data. We therefore forecast organic growth to pick up slightly from recent years (2023: 0% and 2024e: -2%). However, growth remains sluggish compared to the five years prior to the weak cycle (2018-2022: 8-16%). We expect the companies most affected by the decline in demand for custom software development (Witted, Silicon, Vincit) to continue to underperform. Witted is supported by Norway’s more active market.

Although the comparison periods are already weak for most companies, their expert capacities have decreased significantly compared to the level at the beginning of 2024. We estimate that there is more capacity without projects ("on the bench") than usual and that the factors in the big picture are very available at the moment. Significant year-on-year growth would require aggressive hiring, which we do not believe will occur in the near term. Therefore, our growth expectations are clearly concentrated in H2'25. The key for investors, however, is to see volumes picking up on a monthly and quarterly basis and a strengthening demand outlook.

We expect profitability to improve driven by cost savings

In 2024, a clear divergence in profitability has been seen and some companies will see an improvement in profitability next year from very low levels. In 2025, we estimate the median EBITA margin of the companies in our coverage to rise to 6.9% (2024e: 4.1% and 2018-2023 average 7.5%). A better picture of the sector's profitability trend is provided by the average, which rises to 7.5% from 6.3% in the previous year. Profitability will be supported by the savings measures taken, better billing rates and flat or gradually increasing revenues. It now appears that the sector’s profitability bottoms were hit in 2023, when the decline in demand suddenly materialized for most. We expect profitability challenges to continue due to the difficulty of managing billing rates as project starts are delayed and growth is difficult to achieve. Wage inflation will remain moderate, but price competition will continue to put pressure on profitability. Staff turnover has not been a challenge in recent years and will not be as long as customer demand remains weak. Pricing pressure remains our biggest concern in the industry and has already poisoned the order books of several operators, making the return to better profitability levels 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. However, several companies have adjusted their cost structures in the weak cycle, which means that profitability could return to much better levels, at least temporarily, as the market improves.

We expect the profitability of the top four (Gofore, Tietoevry, Netum and Digia) and Siiil to remain at last year's level in 2025. We expect profitability improvements from Digital Workforce, Solteq, Vincit and smaller ones from Loiste and Witted.

A comprehensive summary of the IT services sector and company-by-company comments on the Q3’24 results can be found here.

.Valuation levels expect weak development in the coming years

Earnings performance is a key driver of stock prices, but a third important component of expected returns, in addition to capital allocation, is the level of valuation at the time of purchase. We believe that the valuation level has already reversed to a very attractive position in a historical context. Historically, valuation levels have not recovered without a turnaround in the business and the start of earnings growth. Another factor to note is that several companies in the sector made significant adjustments to their earnings, and the actual cash flow results were worse than the adjusted results. This is partly why the valuation levels, which take these adjustments into account, appear "too" low in some places. It is therefore important for investors to understand how well adjusted operating income translates into cash flow and which items are really one-offs. The most obvious adjustment is goodwill amortization and PPA amortization from acquisitions, which have no cash flow impact.