Testing times: Stockopedia talks to the management team behind SQS Software Quality Systems

When Rudolf van Megen co-founded Sqs Software Quality Systems Ag (LON:SQS) in 1982, he set out to build a software testing business that offered an outsourced option for companies that were grappling with increasingly complex technology and the challenges of getting software systems to work together correctly. These days, SQS is one of the world’s largest pure play suppliers of independent software testing and quality management services but the company remains focused on adapting its business model to meet market demands.

During the last 18 months SQS has invested significantly in building its presence and capacity to handle lucrative and longer-term managed services contracts by growing its offshore capabilities and hiring and training new staff. In the half year to June, the impact of that strategy dented pre-tax profits – down to €2.4m from €2.7m previously – but turnover was up by 9.4% to €73.9m as the percentage of sales from managed services rose from 3% to 7%, on orders worth €40m during the period.

Among its first-half contact wins, the company picked up deals with financial services groups Allianz and SEB; retailers Morrison (WM) Supermarkets (LON:MRW) and Sainsbury (J) (LON:SBRY); energy groups Noble Oil (NYSE:NBL) and Statoil (OSE: STL, NYSE: STO) and technology groups Nokia (NYSE:NOK) and Pace Micro Technology (LON:PIC) . For the management team at SQS – including CEO Rudolf van Megen, CFO Rene Gawron and executive director David Cotterell, the five year plan is to have 50% of group revenues derived from managed services. Stockopedia spoke to the SQS management team about their plans for growing the business in the future.

Rudolf, would it be fair to say that you are satisfied with your interim results given the economic conditions during the last 18 months?

Rudolf van Megen: On one hand, yes, we are. But on the other hand we are also happy that we are back to growth and that we have made investments to really grow and improve in the second half and into the future.

You will have probably recognised that SQS is focused on investing for the long term. What we could have done is focus on short term investment but we are always focusing on the long run. And one of the long run topics over the last two years was to add additional business from what we call a managed testing service to the project consultancy work, which is really a complementary part of the life cycle of IT projects. In the market for maintenance of systems there is a huge amount of business and testing that could be given to external parties and in this respect we started to grow last year with 3% of revenue, we are now at 7% of revenue and we will continue to move this to 50% of revenue in the medium term. So it’s not magic but we’ve taken the right steps, we have some advantages. In managed testing services we have adopted a multi language strategy, which means that our three test centres around the world have most of the necessary languages of the countries where we work. We have a German speaking test centre in Egypt that was set up a few years ago which is low cost but has the advantage of German speaking people.

Rene Gawron: I think we’re definitely very happy. We’ve always been a growth company; when we came to the market here in London five years ago we were a £48/49m company and we are now heading towards £150m, so we are definitely happy that after a year where we were not growing, 2009, we’re back to solid growth in the first half of the year and expecting a little bit more to come in the second half.

Pre-tax profits were down a little bit but this was mostly because we were making investments. This is a people business and if the market is there you need to hire people, which costs money, you need to train the people and this makes them non-billable for a short time. But we added a net of 164 fee earning consultants to our company, mostly in Q2, and these people are now fully trained and are available and are contributing to earning money and gross margins in the second half. We also made some investments in winning managed services deals, and the good thing is we won those deals, worth around €40m, which is providing better visibility going forward. The final thing on the metrics is that utilisation of billable staff, which was a key thing we suffered from last year, has come back to normal levels. So the reason why the PBT is down is not because of a bad market or low utilisation, it’s actually on good investments which will pay off and show their effect, a positive effect, in the second half and in 2011.

Do you have a sense that the market is strengthening for you?

Rene Gawron: That’s absolutely right and this is supported by market statistics, especially the market for testing contracts awarded independent from the development contract, which is a market segment that is expected to grow by 11-12% in the next few years. The market for where testing is given out as part of a development contract didn’t grow last year, and overall it is growing at a much slower rate. So we’ve always been positioned there as an independent but I think that market studies support that fact that we are positioned just right and we’re seeing the effects. If we look at some system integrators that also do testing, in the first half of this year, CapGemini or Logicacmg (LON:LOG), they were still shrinking. But in the first half we were back to solid growth rates of 10%. So I think we are well positioned and that’s why we were confident to invest some of the money to capitalise on further growth opportunities.

You have continued to grow your revenues in managed services and you have clearly got big ambitions for the longer-term. What particular factors are driving your strategy to move into that area?

David Cotterell: From our clients’ point of view, they want typically to get testing out of their organisation because it’s not core to them, they want to put it in the hands of an organisation that has got proven expertise and typically these contracts are for several years in duration. From our standpoint it gives us predictability in terms of consulting utilisation and visibility of earning. In terms of the market size, which is the backdrop to this whole discussion, the market is massive, it’s £4.5bn of testing services required for the activities that are externalised and SQS takes 10% of the stand alone element of that, or 1% of the gross amount if you will, but that discounts the 80% that’s still internal in companies.

You picked up 91 new clients during the first half of the year, in a variety of sectors and for a variety of reasons. Is it easy for you to pinpoint where the growth areas are for you or is it just a broad ranging thing?

David Cotterell: Typically, irrespective of economic activity or what the purpose of the organisation is, whether it’s public sector, utilities, oil and gas or banking, technology is underpinning all these businesses and activities and it is getting more and more complicated. Organisations introduce new things, like a money laundering application into a big insurance company in Stockholm – they have to test all the other applications to make sure that there is no regression and so that is where a company like SQS comes in, we’ll do the testing to make sure that all the other pieces that were working fine aren’t going to be affected negatively. So the more technology gets adopted and the more complicated it becomes, both of those dynamics are occurring daily, the better the market becomes for us really.

Does that bring you to a point where, in terms of your expansion and growth strategies, you feel that you could make acquisitions or move into new territories?

Rudolf van Megen: Definitely, we could but we have taken a decision, and this is really a strategic one for us, that this year you will not see any acquisitions. We want to focus the team and really concentrate on winning another couple of managed service deals on the one hand but also continue organic growth because organic growth is where we have a proven track record. The highest degree of organic growth came in 2007, when we did 27% organic – next to 26% through acquisitions. This is the best growth you can have for the shareholders and also for the organisation. So from that point we don’t want to defocus. On the other hand we are looking into doing something acquisitive next year in areas where we have big, white spaces on the landscape. Our principle is that we are looking for acquisitions that can markedly improve our company. If there is an opportunity, as there was in the UK in 2006 and which markedly improved our position in the UK, that is something that we will look at.

Thank you for talking to Stockopedia

Rudolf van Megen: Thank you very much.