Software Quality Systems (LON:SQS) - is the worst over?

Sqs Software Quality Systems Ag is another one of those tech stocks that I've been looking at as a recurring income play.  It has businesses in Germany and the UK which provide an outsourced software testing service - very much the kind of 'picks and shovels' story I liked when the internet was booming, and still do.

Apparently,  up to a fifth of software projects fail, either not achieving what they were expected to, or conflicting with other systems or processes. Sometimes time constraints are responsible, sometimes departmental politics, sometimes the fact that the specifications weren't tightly enough drawn. But a 20% failure rate is obviously a concern - and one that SQS, as the largest single global player in outsourced testing [ref] SQS web site -  http://www.sqs-uk.com [/ref] can address impartially.

Recent years have seen not just strong growth in testing, but also a gradual shift from software testing on a tactical level, when a problem has been identified with a new installation, to a continuous testing strategy to ensure quality control over the whole lifecycle of software and systems. SQS focuses on the values of the business - testing first those systems and processes that are business critical. That has brought it success - 50% of FTSE 100 and DAX 30 companies are clients [ref] Edison research, May 2009: http://www.edisoninvestmentresearch.co.uk/research/category/SQS-Software-Quality-Systems-AG/ [/ref] .

Independent software testing still accounts for less than 20% of the total software testing market, so there's still room for the sector to grow. And SQS has been migrating clients away from one-off testing to a managed services model, which should help create a strong recurring income stream. That underpins the long term attractions of the business.
SQS is a global company, with offices in Austria, Egypt, South Africa, the Netherlands, Norway, Sweden, Finland, India, Ireland, Switzerland and the US, as well as Germany and the UK. It's also developed a blend between onshore and offshore testing, which gives it the ability to compete on price as well as quality.

SQS looks pretty defensive, but it hasn't been completely unaffected by the economic environment. Its 2008 results were solid, showing organic growth in all divisions and an 18% growth in revenue, with 10% growth in the dividend (after allowing for a special payment in 2007, which skews the headline figures). However, May 2009 saw a profit warning, and though the interim results for 2009 were solid, business still hasn't recovered to earlier levels.

On the other hand October and November 2009 saw two announcements of multiple contract wins, which suggests business is strengthening [ref] http://www.sqs-uk.com/press_archive.php# [/ref] .

Most recently, SQS has put out a trading update [ref] 13 January 2009: ]http://www.stockopedia.com/news/announcement/SQS/100113sqs000604.htm?title=SQS%20Software%20Quality%20Trading%20Update&date=1263340800 [/ref] which shows utilisation levels back up to normal, though pricing is not fully recovered. Now in my experience, it's low utilisation rates that really hurt - if a company has its consultants occupied, and it's making a margin on them, then it will be profitable and able to invest in further development, and then any upturn in rates gives you an added kicker. So I'm beginning to feel that the worst could be over.

Is the company good value? Edison, which provides regular forecasts on SQS, is forecasting £142m revenue this year,very slightly down on last year, giving £7m pretax profit (down from £13.1m) and earnings of 16.6p. Edison is also predicting a dividend cut from 9.6p to 5.2p.  At the current share price of 227p that gives us 13.7x earnings, with a 2.3% yield. I don't find that particularly compelling value, unless we believe the company will return to growth. In particular, I remember that in 2003, tech stocks like this were selling on single figure PERs - though some of that was an overreaction to the tech boom and bust, which we can't really expect this time round.

However, the recurring income play, and the good pipeline of contracts won in the past three months, may suggest that things may not be going to get a lot worse, even if a full blown recovery doesn't happen.