Wednesday, December 8, 2010

SQS Software Quality Systems Trading Update Should Lead to Analysts Upgrades

SQS Trading Update

SQS Software Quality Systems AG gave a trading statement today. They style themselves as the world's largest pure play supplier of independent software testing and quality management services. I think this is an attractive market to be in because IP (and embedded software) is becoming an ever increasing part of a typical goods value. Therefore, software testing services should be able to grow at a faster pace than IT services in general. I should note that this is a German company but it is listed in the UK market. They report in Euros, so be careful when looking at analyst forecasts.

SQS Managed Service Contracts

The last point alludes to the fact that SQS is still a cyclical play and indeed, they were hit in 2008-09. However, the strategy of the company has been to try and move towards managed service contracts and away from purely project work. The problem with the project work is that it is short term and visibility is low. It therefore leaves SQS to be exposed to the cyclical nature of the economy and to suffering from having consultants under utilised.

Unfortunately, in 2008 they underwent an expansion in consultants at precisely the time when their end markets turned down. They learnt the lesson and, are now moving towards manged services as well as increasing the portion of their staff in offshore (lower cost) centres. It seems to be working...

The Company has recently won three new Managed Services contracts and extended three existing ones, such that order intake for the Managed Services division has exceeded €50 million in the year to date. A Managed Services contract can be expected to provide improved visibility of earnings and enhanced margins, compared to a traditional project, over the entire life cycle of the engagement, although it may involve lower margins in the initial phases as the majority of work is carried out by onshore consultants during this time.
...and this is a good update. SQS trades at a share price of 195p and a £53m market cap which-according to analyst forecasts- puts it on PE ratio of 10.3x and 8x for 2010 and 2011 respectively. I think that analysts will have to raise forecasts after this update, however a trading update is due in January.

Catalysts for a Re-Rating

There a catalyst for a re-rating due to a reduction in risk due to taking on more longer term managed services contracts. Furthermore, on evaluation grounds it is clearly undervalued. However, investors maybe overlooking the potential for some M & A activity. The management hold the stock tightly, but it's attractions to a bidder are obvious.

Firstly, it provides a high growth niche area of IT services. Secondly, for an Indian IT services company, it would present an ideal way to add scale in Europe and they should be able to increase margins by shifting work to their staff in India. Thirdly, the evaluation is compelling.

I hold a position.

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