SQS Group (SQS)

SQS is an obscure company in many ways. It occupies an unglamorous niche of the IT sector, software testing. Its German management team has a somewhat quirky presentational style. And because several institutions are holding on to large chunks of the shares available, it isn’t traded very much by private investors.

These issues have masked a strong growth story, though. Double-digit organic revenue growth is impressive for any IT services company, but all the more so for one which has been around for over 25 years. With its 2007 results, it achieved its ambition set out at the time of its September 2005 AIM float of doubling revenues in two years. It’s even more remarkable, then, that the shares are trading at just 9.5 times 2008 forecast earnings, which is well below the software and IT services sector average of 11 times, even though SQS is a well-established leader in its market. Its margins are also strong, suggesting a premium may be warranted. “We believe the business could easily sit on a 12- to 15-times current-year earnings rating and we feel forecasts are conservative,” says Roger Phillips, analyst at house broker Evolution Securities.

One reason for the valuation disparity is that SQS derives 28 per cent of its sales from the financial services sector. Investors, who have fled the IT sector in general over the last six months, are particularly nervous about IT spending in financial institutions, as banks look to cut costs.

SQS’ chief executive Rudolph van Megen denies this presents any substantial risk. First, rapid growth in other sectors means the number of clients in financial services is down to 5 per cent, with revenues in that space likely to make up 15 to 20 per cent of the total in 2008. Secondly, demand remains strong from banks and the necessity of software testing means that is unlikely to change. “Why should we stop working in financial areas if we have lots of projects and new requests for business?” says Mr van Megen.

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Software testing is necessary throughout the life of an application or service, not just when it’s being installed. The slightest change could create errors elsewhere in the package, or in connections with other systems. Only 20 per cent of testing costs are in new projects, says Mr van Megen, while two-thirds of the project’s maintenance costs are in testing. By providing specialist services with economies of scale that are hard to replicate even in large IT departments, SQS can undertake this testing work more cheaply - up to 50 per cent less - than in-house testing teams, he says. As well as being a defensive niche within IT services, testing is also less vulnerable to competition from offshore outsourcers.

Most reassuring for nervous investors is SQS’s high proportion of recurring revenues from such latter-stage services. Over half of 2008’s revenues are already secured through contracts, up from an estimated 45 per cent last year.

SQS’s market leadership in Europe leaves it well placed to consolidate the market and has its eyes on the Austrian, Benelux and Northern European markets. It has the cash to expand and no plans to raise more funds from the stock market. And the potential risks of expansion are further reduced by management’s apparently low appetite for deals in far-flung markets such as the US or Asia.

So it shouldn’t be surprising that those already holding SQS shares are reluctant to part with them. That does contribute to a liquidity problem. However, the departure of co-founder and chief operating officer Heniz Bons – who owns just under 20 per cent of the shares in issue – could see more shares come to the market. Analysts say that the improved liquidity would help the share price, rather than create selling pressure. A projected increase in shares from deferred payments for past acquisitions means earnings are set to fall next year, coupled with the impact of a rising tax rate. That hasn’t stopped the chief executive and finance director both increasing their stakes since March’s results.