Do you remember the scrapping of the new NHS computer system a couple of years ago? It was a bit of fiasco at the time. The government had billed this project as a great milestone for the NHS – a system that would herald a radically more efficient health service.
Only it soon became clear that this new system was unlikely to deliver the results it promised. So they pulled the plug. And to be fair, that was a pretty brave decision.
The problem was that the project had burned through £6.4bn of taxpayers’ money. The latest estimate is for a £9.8bn write-off; and this is likely to rise even further as all the contracts are unwound.
It would be nice to think that this fiasco would ensure government IT procurement would be transformed and that procedures would be put in place to ensure it could never happen again. But I can’t see that happening. And that leads me to great little company that might have prevented this whole fiasco in the first place.
An £11bn market that just keeps growing
How do we stop big businesses from making a mess when they invest in new computer systems? Well, most sensible people who commission software projects can see the benefit in testing at an early stage.
Like a stitch in time that saves nine, detecting a software problem early will save a lot of time and money.
The nightmare scenario is that a problem only becomes apparent when the system is up and running.
As an investor, I was always nervous of retailers automating their warehouses with new enterprise software – it often seemed to go wrong, resulting in stock not getting to the stores and causing massive disruption.
Given its critically important nature, specialist software testing has become an $11bn market. The growth rate is also healthy according to researchers Nelson Hall, with US demand rising by 9% this year and European demand by 5%. These rates are expected to improve further next year. And there are great companies in this sector.
Remote access: the SQS success story
The market can be split in two: the independents and the big systems integrators like IBM and Accenture who carry out testing as part of a larger IT contract. In fact, the testing element is usually worth 30% of the budget for a big IT project.
The world’s largest independent tester is a German company which happens to trade on Aim. SQS Software Quality Systems (AIM: SQS) was founded 30 years ago and listed in 2005. Its role is to provide impartial scrutiny of the quality and efficiency of software.
SQS used to do this in its regular testing services (RTS) business. Here, five consultants might move onto a client’s site for a couple of months to test a new software project. The contract would be completed, and they would move on to the next job.
The problem with this is that it isn’t very scalable. Like most professional service firms, your billings are limited by the number of hours in a consultant’s day. To grow you have to add people and manage their hours. So, SQS changed its business. And that has made all the difference.
They still carry out RTS contracts, but ‘managed services’ (MS) is becoming the larger part of the business.
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MS is a way of introducing scale economies into the business. Rather than consultants sitting in a client’s office, the testing is carried out in offshore centres.
Testers in India or Cairo are much cheaper, but can do the job just as effectively, having remote access to the client’s system.
This need for remote access encourages long-term rather than ad hoc contracts. Testing is supplied as an on-going managed service.
A good example is SQS’s relationship with Volkswagen. Given the scale of VW’s IT system, some software code will be updated every day. This necessitates continual testing of the entire system to assure its quality.
Automotive manufacturing, with its just-in-time procurement and logistics, is an industry where any system glitches or downtime can be very costly.
As well as providing scale and longer-term contracts, the MS model also brings higher margins.
SQS is going to continue with the RTS short-term contracts, because they can be a good way of building relationships with new customers.
Those customers come from across a broad range of industries and include many household names such as JP Morgan, Aviva, Vodafone and BP. But the push into MS is really helping to drive profits.
SQS looks a quality growth stock
SQS looks like a good quality growth stock to me. The longer term history was OK if a little patchy. The shares floated at 190p, and then moved broadly sideways for six years.
In fact, you could have bought them for 150p at the start of 2012. But since then, they have trebled to 450p.
Does this mean they are fully valued and all the good news is in the price? Broker Canaccord Genuity forecasts €0.38 earnings per share for 2014, followed by €0.44, which is a three-year annualised growth rate of 22%.
At 450p, the shares trade on a price/earnings (p/e) ratio of 14.2 next year, falling to 12.3 in 2015. This doesn’t look demanding given the growth rate in what is a cash generative business. So this is one technology story that is worth keeping an eye on.
Two words of caution: the shares are up 80% this year, and although I really like shares with momentum, they might be due a pause.
The other point to bear in mind is that SQS is keen to increase its US footprint and to expand its offshoring capacity.
This could well result in one or two fairly large deals over the next year or so which might also mean new equity being issued. If either of these factors present us with a buying opportunity, I think they are well worth considering.
• This article is taken from our free twice-weekly small-cap investment email, The Penny Sleuth. Sign up to The Penny Sleuth here.
Information in The Penny Sleuth is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. The Penny Sleuth is an unregulated product published by Fleet Street Publications Ltd. Fleet Street Publications Ltd is authorised and regulated by the Financial Conduct Authority. FCA No 115234. http://www.fsa.gov.uk/register/home.do
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