After a strong period of share price performance which saw a four-fold return between 2012 and the middle of last year, SQS Software Quality Systems (AIM: SQS) is encountering a few headwinds. Downgrades following the results have knocked the shares back 11 per cent.
The growth driver in recent years has been Managed Services (MS) which accounts for around half the business. Here SQS typically has a 3-to-5 year outsourcing contract to test a company’s software on a daily basis, including all updates and additions to the system. The long term nature of the deals gives visibility and allows costs to be controlled in offshore testing centres located in India and Eastern Europe.
However this is changing. The industry has been moving to shorter term deals and asking SQS to do more for the same money. As CEO Diederik Vos puts it, just as his major client VW puts more technology into a car while charging the same as before, so too VW and their ilk demand more from their suppliers. As a result the MS division is struggling to grow after a prosperous period. This follows on from the ‘sustainable managed decline’ of the Professional Services division, which carries out ad hoc projects, and came under margin pressure a couple of years ago.
The bright spot is Management Consultancy which focuses on higher-value bespoke projects and rose to 18 per cent of group sales from 11 per cent a year ago. This is responding to the increased global demand for digital engagement. Companies need SQS’ skills to develop fresh standards and protocols for testing new digital systems in fast-changing markets.
SQS does a good job of generating cash, which gives it scope to continue augmenting growth through acquisitions. It’s possible we will see activity here this year after a period of digesting 2015’s deals. However the subdued outlook in MS means there are downgrades. Growth is expected to be sub 5 per cent and with the shares at 555p, they now trade on a prospective p/e of 13 times.