Shares digital

SQS Software Quality Systems (SQS:AIM) – 270p, stop loss 216p

SHARES SUMMARY

Concerns over the IT spending cycle linger but accelerating top line momentum means SQS should enjoy further economies of scale and generate earnings leverage, while the valuation remains lowly.

Business:

The German firm is Europe’s largest independent provider of software testing services, with 450 blue-chip clients worldwide.

Vital stats:

Market value: £58.2m

Historic PE (2007): 9.1

Prospective PE (2008): 7.9

Prospective PE (2009): 7.8

Sector PE: 25.9

1m relative strength: 14.3%

12m relative strength: 30.5%

Yield: 3%

NMS: 500

Spread: 2.2%

A business that is a leader in its field, growing rapidly and cash generative is an asset to be prized during these times of economic uncertainty, particularly if more than half of forecast revenues for 2008 have already been booked or contracted. Yet SQS Software Quality Systems trades on a prospective PE of barely eight times for 2008, and if past history is any guide this could well be based on earnings growth forecasts which prove too conservative, even allowing for a rising tax charge.

SQS Software Quality Systems is Europe’s largest independent provider of software testing and quality management services. Demand is driven by customers’ needs to meet exacting regulatory requirements, such as those posed by Basel-II or MiFID, and the continued trend toward outsourcing IT projects. This trend is based on companies’ desire to focus on their core expertise, while cutting costs. Management point to a slew of surveys which show that the majority of global IT projects are not delivered on time or within budget.

SQS, which became the first German technology firm to float on Aim when it listed at 190p in September 2005, is naturally very strong in its domestic market, and can count over half of the Dax-30 as customers. But a blue-chip client base of some 450 firms includes 36 FTSE 100 constituents, notably Barclays (BARC) and BP (BP.). In addition to Germany and the UK, SQS also has offices in Austria, Ireland, the Netherlands, South Africa

and Switzerland.

Although 55 key accounts yield two-thirds of SQS’s sales, a focus on increasing the breadth of the firm’s customer base has paid off, as the largest account now generates just 7% of group sales and new verticals such as legal and media, and technology are generating rapid growth, as well as reducing reliance on the financial services sector.

The shares in the £58 million cap rallied nicely after last week’s excellent full-year results, which even surpassed the figures suggested by last November’s chirpy trading update. Organic sales growth accelerated to 27%, both recent acquisitions, Cresta and Triton, settled in well and SQS even announced a maiden dividend payment.

Yet at 270p the stock still lies some 10% below the 301.5p all-time high achieved last autumn, before the credit crunch knocked market confidence, and on that lowly forward PE.

That is not to say there are no risks. The financial services sector still provides more than a quarter of group sales and IT spending cutbacks remain a threat here, particularly to SQS’s consultancy and training operations, as the credit crunch grinds on. Any acquisition presents a challenge and a plan to attack Asia will take management into unfamiliar territory.

Finally, the stock is not especially liquid, as current chief executive Rudolf van Megen and former chief operating officer Heinz Bons, who co-founded the firm between them 25 years ago, still own 37% of the shares.

But none of this prevented either van Megen or chief financial officer Rene Gawron from buying more shares after the publication of the full-year results, and investors should follow their lead.

by: Russ Mould