Gamble of the week: Quality software tester

By Paul Hill Jan 20, 2012

Paul Hill

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It’s an IT manager’s nightmare: last Thursday, alongside a 16% dive in Tesco’s shares, came news that one of the retailer’s computers had mis-priced thousands of packs of Cadbury Mini Eggs (worth £1.50 each) at 1p each. Not ideal timing.

There was no lasting damage this time. Yet it shows the need to use independent specialists to test software upgrades. Having a fresh pair of eyes review complex code before it goes live helps to avoid these sorts of embarrassing hiccups – which can cause untold financial damage and harm a firm’s reputation (as happened during Blackberry’s communication outages).

SQS is Europe’s largest independent software tester. The company operates in a €1.5bn market that is growing at 6.5% a year. It employs 1,664 consultants, of whom 30% are based offshore. Clients include Barclays, JP Morgan and BP.

One obvious concern has been the impact of a slowing economy on jobs. To its credit, the board saw this coming, and is scaling back recruitment in the firm’s more cyclical areas.

And SQS is still winning work, particularly in its managed services arm, where contracts typically last for two to five years. On 30 November, it won a two-and-a-half-year, €20m deal with a global financial services group, pushing the 2011 managed services order intake up to €62m. In three years’ time, the aim is for this division to contribute 50% of the group’s revenues, up from 20% today.

SQS Software (Aim: SQS)

SQS share price 

The City expects 2011 revenues and underlying earnings per share (EPS) of €186m and 25.5 cents respectively, climbing to €200m and 30.7 cents in 2012. That puts the shares on an undemanding price/earnings ratio of 8.3, while paying a 4% dividend yield. I rate the group on a through-cycle EBITA multiple of nine. If you adjust for the €20.6m of net debt (including finance leases, bonded loans and deferred consideration), that delivers a value of 235p a share.

Debt levels, while comfortable at less than 1.5 times EBITDA, need to be watched, especially as new managed services
deals require upfront investment in working capital. SQS is exposed to the troubled financial services sector (40% of
sales), and also recently failed to recover €2m of transition expenses relating to two projects. There are competition and foreign-exchange risks, and liquidity in the stock can be poor at times.

Preliminary results are scheduled for 6 March. House broker Arbuthnot has a “strong buy” rating with a 275p price target.

Rating: SPECULATIVE BUY at 165p (market capitalisation £47m)

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