Review of Q3 2023

Total sales largely matched our forecast of SEK155m and amounted to SEK154m (128), corresponding to 20% growth y/y. The y/y growth was driven by positive net recruitment y/y, higher sales per employee and working day, and several acquisitions. The organic growth y/y was solid at 7.7%, especially considering Q3 this year had one working day less than Q3 2022 and the current market environment. We note that most peers have shown lower or negative organic growth in the quarter.

The situation is seen in Q2, with lower demand from some sectors, including consumer discretionary, housing, and construction, while most sectors see normal markets remain. Management points out that the demand for CombinedX’s specialist services remains solid in most cases, highlighting several ongoing projects related to AI and ML. For example, Elvenite is helping Lantmännen optimise the treatment of seeds and the aquaculture industry by anticipating diseases.

An IT consultant’s sales are a function of the number of employees and their revenue per working day. In reality, the number of revenue-generating employees, i. e., excluding administrative personnel etc., would be a better measure. However, we cannot access those figures, making the total number of employees a reasonable proxy.

While management retains its market view from Q2, considering the high net intake of employees, we believe management now has a higher conviction in its rather optimistic market outlook. Our discussions with management support that view.

As seen in Q1-Q3 2022, the average number of employees is lower than the incoming and outgoing numbers, which could imply higher employee churn. However, according to management, the employee churn has not increased. Instead, it is likely a seasonal effect. The strong per-employee and working-day data discussed below supports the statement of stable employee churn.

The number of employees at the end of the quarter is a leading indicator for sales growth in the coming quarter. While sales is dependent on other parameters as well, the starting number of employees for the coming quarter is, together with the number of working days, the only relevant figures we know in advance.

The difference between the average number of employees and the number of employees at the end of the quarter can give us a clue about the employee churn. For example, during Q2-Q3 2022, CombinedX started and ended the quarter with more employees than the quarter’s average, i.e., a U-shaped employee curve. That indicates a high employee churn over those quarters. In Q4 2022, the average number of employees started to coverage towards the number of employees at the end of the quarter, implying a reduced employee churn.

Employee churn is typically costly for any company. However, as IT consultants’ sales generation depends on their employees in a nearly 1:1 ratio, we believe low employee churn is even more important in IT consultant firms.

The Sales-COGS/employees/working day is a proxy for the revenue generation of one employee during one working day, indicating how advanced services the company provides and how high its utilisation rate is. While sub-consultants and reselling software and hardware can alter accuracy in this measure, we try to consider that by subtracting the cost of goods sold, which typically consists mainly of expenses related to sub-consultants and reselling. Also, as we use the total number of employees, the share of administrative personnel can alter the number. A high share of administrative personnel might not be unwanted. For example, when focusing on expansion, the investments in administration are typically front-loaded.

The Contribution/employee/working day is sales-cogs-personnel expenses and indicates the profit contribution for the average employee per working day. We believe it is a proxy of how much revenue consultants generate compared to their seniority and, thus, salary. For example, a high Sales-COGS/employees/working day might not be worth much to shareholders if most are paid as salaries to senior consultants.

Overall, OPEX was slightly higher than our forecast of SEK108m and amounted to SEK110m (96). Other external costs exceeded our forecasts, likely due to the group-wide conference in Karlstad that we did not consider. Personnel expenses were somewhat lower compared to our expectations. While the SEK2m difference might seem rather minor, in a small quarter like Q3, it still substantially affects EBIT.

EBIT was SEK9.7m, corresponding to an EBIT margin of 6.3% (2.8). Our forecast was SEK13.0m and 8.4%, and the lower outcome was due to somewhat lower sales and SEK2m in higher OPEX. Thus, despite small deviations in sales and OPEX, EBIT was 25% below our expectations. Free cash flow (excluding M&A) was SEK-3.2m (-11.6). Excluding changes in net working capital, free cash flow was SEK6.1m (-1.3). Both FCFs include leasing payments. Thus, the cash flow was soft due to a negative contribution from net working capital. However, that is mainly for seasonality, as 30 September was a Saturday. We have seen a similar pattern in several IT consulting/software companies.

As expected, from an IT consulting business, the cash generation is solid, and by the end of Q3 2023, CombinedX had a net cash position of SEK54m, excluding leasing.

As common among IT consultants, CombinedX has low CAPEX, and the cash conversion tends to be strong.

For 2023, we cut our EBIT forecast by 6% while keeping sales unchanged. The reduction is largely due to the lower outcome in Q3 than expected. For 2024, we raise sales and EBIT by 1-2% for the following main reasons:

We lowered our Base Case to SEK57 (60) because we increased our risk-free rate from 2.5% to 3%, resulting in a higher WACC. The effects from underlying forecast adjustments are minor.

CombinedX is trading at a significant discount to the peer average and median. While the company has a short track record, which should motivate some discount, given our positive outlook on CombiendX operations and the strong recent quarterly reports, we believe the gap will narrow.