Half Yearly Report

3 September 2014

SQS Software Quality Systems AG

("SQS" or the "Company")

Results for the six months ended 30 June 2014

SQS Software Quality Systems AG (AIM: SQS.L), the world's largest supplier of independent software testing and quality management services, today announces its unaudited results for the six months ended 30 June 2014.

Financial Highlights:

· Turnover increased by 20.0% to €129.4m (H1 2013: €107.8m)

· Adjusted* Gross profit increased by 28.7% to €42.8m (H1 2013: €33.2m)

· Adjusted** PBT increased by 86.7% to €8.5m (H1 2013: €4.5m)

· Adjusted*** EPS increased by 50.0% to €0.18 (H1 2013: €0.12)

· Net debt as of 30 June reduced by 13.6% to €8.9m (H1 2013: €10.3m)****

· Operating cash flow lower at €-2.6m (H1 2013: €4.4m)

* adjusted to add back €1.0m of IFRS amortization of order backlog from Thinksoft (now SQS India BFSI) acquisition

** adjusted to add back effect under * and €2.6m of IFRS amortization of client relationship assets from Thinksoft (now SQS India BFSI) acquisition, €0.6m of non-recurring severance costs for the Thinksoft founders and €0.2m acquisition costs for Thinksoft

*** adjusted to add back effect under ** and €0.4m of pro forma IFRS forex adjustments of Thinksoft acquisition value, at actual local GAAP tax rate of 29%, less €0.6m on minority interests

****after cash investment of €5m in Thinksoft (now SQS India BFSI) in the last 12 months and investment in Pune test centre facilities of c. €0.5m

Operational Highlights:

· Revenues from Managed Services contracts up 35.3% to €57m (H1 2013: €42m), now accounting for 44% of total revenue, in line with our stated strategy (H1 2013: 39%)

· Managed Services contracts gross margin improved to 35.7% (H1 2013: 33.2%)

· Improving visibility with Managed Services order intake up 43% on prior year period at €70.0m (H1 2013: €49.0m)

· Average revenue per client has increased by 25%compared with H1 2013 as a result of a continued focus on larger, higher value client engagements

· Offshore/nearshore test centre billable headcount increased to 62% of total billable headcount (H1 2013: 44%)

· Increase of receivables and work in progress of €14.3m over H1 2013 resulting from typical seasonal behaviour of few large managed services clients and an increase of €7.6m receivables from the Thinksoft first time consolidation

· US revenues increased 263% to €5.8m (H1 2013: €1.6m) now accounting for 4.5% of total revenues

· Acquisition of majority stake in Thinksoft completed, renamed SQS India BFSI and now fully integrated

Diederik Vos, Chief Executive Officer of SQS, commented: "We are delighted with our performance during the first six months of 2014 in which we have made significant progress across most metrics, and profitability in particular. This has been achieved through our continuing focus on larger, higher value contracts and through ongoing margin improvement in our growing Managed Services business as contracts are increasingly serviced from our expanding offshore and nearshore facilities.

"These results include a full contribution from Thinksoft (now SQS India BFSI), which has now been fully integrated into the Company. SQS India BFSI has progressed in line with our expectations and has greatly expanded our reach in key geographies such as the US, our capabilities in core sectors such as banking and finance, and our global delivery capability.

"Our strong first half performance has continued into the second half and this, combined with our enhanced order intake for Managed Services, gives us confidence in meeting our expectations for the full year."

Enquiries:

A copy of this announcement will be available on our website, www.sqs.com, today from 07:00am BST.

About SQS

SQS is the world's leading specialist in software quality. This position stems from over 30 years of successful consultancy operations. SQS consultants provide solutions for all aspects of quality throughout the whole software product lifecycle driven by a standardised methodology, offshore automation processes and deep domain knowledge in various industries. Headquartered in Cologne, Germany, the company now employs approximately 3,900 staff. SQS has offices in Germany, the UK, Australia, Egypt, Finland, France, India, Ireland, Malaysia, the Netherlands, Norway, Austria, Singapore, Sweden, Switzerland, South Africa, the UAE and the US. In addition, SQS maintains a minority stake in a company in Portugal. In 2013, SQS generated revenues of €225.8 million.

SQS is the first German company to have a primary listing on AIM a market operated by the London Stock Exchange. In addition, SQS shares are also traded on the German Stock Exchange in Frankfurt am Main.

With over 7,000 completed projects under its belt, SQS has a strong client base, including half of the DAX 30, nearly a third of the STOXX 50 and 20 per cent of the FTSE 100 companies. These include, among others, Allianz, Beazley, BP, Centrica, Commerzbank, Daimler, Deutsche Post, Generali, JP Morgan, Meteor, Reuters, UBS and Volkswagen as well as other companies from the six key industries on which SQS is focussed.

Chief Executive's Statement

Introduction

The six months under review has been a period of significant growth and strategic progress for SQS.

In line with our strategic goals we further increased the proportion of revenues from our Managed Service business to 44% (H1 2013: 39%). This was achieved while simultaneously improving Managed Services gross margins, which now stand at 35.7% (H1 2013: 33.2%). Gross margins from our Managed Services business will continue to improve as contracts are increasingly serviced from our offshore and nearshore test centres.

The proportion of billable staff delivering services from our offshore and nearshore operations has also continued to increase in line with our strategic targets, such that it now stands at 62% (H1 2013: 44%). In addition, as part of our stated strategy to focus on larger, higher-value contracts, our annualized average revenue per client grew by 27% during the six months under review, against the same period last year. 

We continued to grow revenues across the vast majority of geographies in which we operate having experienced strongly increased demand for our services in Ireland, Austria, the Netherlands and Switzerland during the period. Demand also increased at lower single digit rates in our largest region Germany, while demand in the UK has only just begun to pick up during the first 6 months. In addition, we have increased revenues from our nascent US business by 263% (a blend of organic and acquisitive growth from Thinksoft), although further investment into the region will be required if we are to establish a sustainable footprint in the world's largest testing services market. Our Nordic business remains loss-making although restructuring measures, to improve sales efficiency, staff utilisation and reduce overheads, have resulted in an improved performance during the six months under review. The Nordic business now accounts for 4% of the Group's revenues. 

Overall revenues increased 20.0% to €129.4m for the period (H1 2013: €107.8m), including a first time consolidation effect of Thinksoft of €12.2m for the full period. Organic revenue has increased by 9% during the period representing a growth rate slightly above the estimated market growth rates. Adjusted* gross profit increased by 28.7% to €42.8m (H1 2013: €33.2m). The increase in gross profit results from a combination of increasing revenues and a 230 bps improvement in the gross margins to 33.1% (H1 2013 30.8%). The improvements in gross margin have been driven primarily by a growing percentage of contracts being managed in a global delivery mode from our offshore/nearshore test centres.

Adjusted** PBT increased by 86.7% to €8.5m (H1 2013: €4.5m), of which €1.7m came from the first time consolidation of Thinksoft. Organic adjusted PBT growth has been +50.2%, evidencing the impact of the deployment of our strategy.

The focus on fewer and larger Managed Services clients has resulted in a seasonal increase of receivables and work in progress of €14.3m over H1 2013, resulting in a temporary impact on our operating cash flow. This increase includes a €7.6m effect from the first time consolidation of Thinksoft assets. We have generally seen this increase of receivables and work in progress in all previous years during the first half, and are confident that there is no risk on either invoicing or collecting these amounts. We therefore expect an improved cash collection and full profit to cash conversion during the second half of the year.

In summary, the six months under review have seen strong progress toward a number of our strategic targets. These include geographic growth, particularly into key markets such as the US; strengthened capabilities in core sectors, such as in banking and financial services are the result of the acquisition of Thinksoft; and strong growth in our Managed Services business and offshore resources. Together these developments further improve our standing as clear leaders in the independent software testing space and leave us well positioned to capitalise on the growth trends within our markets

* adjusted to add back €1.0m of IFRS amortization of order backlog from Thinksoft (now SQS India BFSI) acquisition

** adjusted to add back effect under * and €2.6m of IFRS amortization of client relationship assets from Thinksoft (now SQS India BFSI) acquisition, €0.6m of non-recurring severance costs for the Thinksoft founders and €0.2m acquisition costs for Thinksoft

New Business

The Company has experienced considerable success in its continuing strategy of focusing on larger, higher-value contracts. Client numbers reduced from 460 (H1 2013) to 423 during the six months under review (H1 2014 incl. the "Thinksoft" clients) which combined with our revenue growth resulted in average annualised revenue per client rising 25% to €0.61m (H1 2013: €0.49m).

Larger contracts and contract extensions signed during the period included a two year extension with a global bank worth more than €30 million, a managed services contract extension with a major European telecommunications provider worth €15 million and a new Managed Services contract with a major European bank worth €10 million.

Total Managed Services order intake has been €70m in the first half, up 43% (H1 2013: €49m), for delivery over the next 24 months.

As the Company continues to grow in scale it is also becoming increasingly capable of servicing ever larger contracts and this is being recognised more broadly by both existing and potential clients. We are therefore confident of making further progress with our strategy of increasing average revenue per client.

Market & Industry Overview

The software testing landscape continued to outperform the overall IT services market during the year. A 2013 Nelson Hall market report, showing an expected growth rate of 7% in testing services for Europe for 2014, has yet to be updated but we are not aware of any market reports that contradict this analysis.

This growth rate was broken down by Nelson Hall to show forecast growth of 9.5% per annum until 2018 in 'Specialist Testing Services' (testing services provided by organisations such as SQS in standalone contracts) against a fall of 3% per annum until 2018 for 'Traditional Testing Services' (services bundled within a development contract). This is attributed to the fact that Specialist Testing Services are perceived by clients as providing faster execution at reduced cost, and confirms that SQS is firmly positioned in the fastest growing segment of the market.

The 2013 Nelson Hall report further supported SQS' strategic focus by highlighting that expected growth was most pronounced in a number of our key sectors. These included retail and logistics (driven by m-commerce and e-commerce), energy and utilities (driven by deregulation) and banking (driven by regulatory compliance). This also adds weight to the rationale behind our acquisition of Thinksoft which greatly complements our capabilities within the banking sector and presence within this market.

The results of the report also supported our Managed Services strategy in revealing that 57% of decisions to purchase software testing services are made by efficiency seeking clients and that there was an increasing move toward larger multi-year contracts. Managed Services contracts are designed to deliver efficiency and are typically significantly larger in size than Regular Testing Services contracts.

Acquisitions

Our acquisition of a majority stake of 53.35% of Thinksoft (now SQS India BFSI) was completed in April of 2014 and full integration was achieved during the period. Thinksoft numbers were fully consolidated in our results from 1 January 2014 onwards.

The acquisition was very much in line with a number of our strategic goals, increasing as it does our global scale, offshore delivery capabilities and domain expertise in the banking, financial services and insurance sector. In addition, the acquisition has given us a presence in new geographies including Australia, Singapore and the Middle East and improved our positioning in key existing markets such as the US, where our sales force has more than doubled as a result. These benefits have the potential to improve our pipeline of opportunities.

SQS continues to consider selective acquisitions with a view to accelerating progress toward achieving our strategic goals. Our core focus is on adding regional markets in Europe and the US and on expanding our delivery capability on key industries with key clients. We hope to be able to announce further developments in this respect in due course.

Strategy

We have maintained our focus on extending the Managed Services share of our business and on a global delivery model by further increasing the share of revenue to be delivered from offshore and nearshore test centres. We continue to build out our business through organic growth and further acquisitions.

Our three primary service offerings remain Managed Services to meet the demand of clients seeking efficiency, Specialist Consultancy Services to meet the demand of clients seeking transformation and quality and Regular Testing Services (RTS) to meet the demand of more price conscious clients, who tend to be served on a local basis.

We have had considerable success in growing our Managed Services business during the period. Our aim is to continue to grow this part of the business as a proportion of total revenues to 50% by the end of next year.

We have continued to be proactive in seeking to improve the margins achievable from our RTS business during the period. This has involved careful targeting of new contracts that are likely to provide greater future value, with a minimum potential value of €1.5m. In addition, we have sought to re-allocate staff in a more cost-effective manner on existing contracts and to discontinue those contracts that are not sufficiently profitable. 

Our strategy of achieving further margin improvement through balancing onsite and test centre delivery has also been successful during the period. In addition, we maintain our focus on targeting new business within the six key industry verticals in which SQS has strongest domain, application and technology expertise. The banking and financial services vertical performed best during the period and the acquisition of Thinksoft has greatly enhanced our positioning in this sector. 

Dividend

In accordance with German law, SQS can only pay one dividend in each financial year. We expect to declare a dividend with our final results for the year ending 31 December 2014, in line with our current policy of paying out a fixed proportion of full year earnings.

Board

During the period Lothar Pauly, owner and Managing Director of Lothar Pauly Management Consulting and a Director of Mobiserve; Bakcell and B2X, was appointed to the Supervisory Board ("the Board").

Additionally, Peter Boelter, a Delivery Manager at SQS and President of intacs e.V, was appointed as an employee representative to the Supervisory Board, according to German company law. Mr. Boelter has worked at SQS since 1988 in a number of roles and brings a wealth of experience in testing, quality assurance and quality management.

At the Company's AGM on 28 May 2014, Prof. Werner Mellis, chairman of SQS's Supervisory Board and member of the Board since 1999 did not seek re-election and consequent to this David Bellin was appointed as Chairman and Lothar Pauly as Vice Chairman of the Board. In addition, Matthias Baunach was not re-elected as employee representative to the Board. Both Prof. Werner Mellis and Matthias Baunach left the Board after the Company's AGM.

The Board would like to thank Prof. Mellis and Matthias Baunach for their contribution to the Company and wish them well for the future.

Employees

Total headcount at the period end had increased 40% during the six months to 3,895 (31 Dec 2013: 2,789) with a further c. 200 contractors retained during the period. As well as organic expansion, this increase includes Thinksoft's 925 staff members which have been included into the total headcount from the beginning of 2014.

To satisfy increasing demand for our Managed Services offerings we have also continued the expansion of our Indian test centre facilities such that offshore/nearshore staff now account for 62% of total billable headcount up from 44% at 30 June 2013. Again, this increase was in a large part as the result of the inclusion of Thinksoft's staff, of which 851 provide offshore delivery services from two test centres in India. 

As a result of this significant increase in offshore staff the share of Group, revenues delivered by test centre resources (offshore and nearshore) jumped significantly during the six months to 28% (Year end 2013: 20%).

Utilisation was slightly below our operational targets at 187 billable days per consultant on an annualised basis (FY 2013: 191 days) due to some upfront investment in test centre delivery capacity.

Outlook

We are delighted with our performance during the first six months of 2014 in which we have made significant progress across most metrics, and profitability in particular. This has been achieved through our continuing focus on larger, higher value contracts and through ongoing margin improvement in our growing Managed Services business as contracts are increasingly serviced from our expanding offshore and nearshore facilities.

These results include a full contribution from Thinksoft (now SQS India BFSI), which has now been fully integrated into the Company. SQS India BFSI has progressed in line with our expectations and has greatly expanded our reach in key geographies such as the US, our capabilities in core sectors such as banking and finance, and our scale and capacity.

Our strong first half performance has continued into the second half and this, combined with our enhanced order intake for Managed Services, gives us confidence in meeting our expectations for the full year.

Diederik Vos, Chief Executive Officer3 September 2014

Financial Review

Summary

Revenues grew by 20.0% to €129.4m (H1 2013: €107.8m), including a first time consolidation effect for the full period of Thinksoft (now SQS India BFSI) of €12.2m. Organic revenue growth has been +9% during the period.

The business units, which represent the accounting segments according to IFRS 8, are:

· Managed Services (MS) to meet the demand of clients seeking efficiency in long-term engagements (between twelve months up to five years) of which a growing share (in many cases) is delivered from nearshore and offshore test centres. This also includes long term engagements for testing standard software package products;

· Specialist Consultancy Services (SCS) to meet the demand of clients seeking transformation and quality in specialized projects with skills like SAP, PLM (Product Lifecycle Management), Process Consulting and Improvement, and Load and Performance Testing as long as these resources are not active in MS projects; and

· Regular Testing Services (RTS) to meet the demand of more price conscious clients in IT projects who tend to be served with a smaller number of consultants on a more local basis and typically contracted for a short term (e.g. three months).

Alongside these major segments there is business with contractors (as far as these have not been included in MS), training & conferences and software product testing tools summarized as "Other".

Breakdown by business unit

Managed Services (MS)

Revenue in MS, our largest segment, amounted to €57.0m in the period (H1 2013: €42.1m), an increase of 35.3%. The improvement in revenue predominantly came from the extension of existing long term managed services contracts and from the first time consolidation of Thinksoft.

Specialist Consultancy Services (SCS)

Our business in this segment saw a decline during the period of -22.7% to €13.1m (H1 2013: €17.0m). This occurred primarily as the result of the reclassification of one major banking client to Managed Services in 2014 and continued demand for these ERP, PLM and process specialists in MS engagements (thus their revenue and margin contribution is counted under MS above).

Regular Testing Services (RTS)

This segment grew by 20.5% in revenues to €47.9m (H1 2013: €39.7m). This sudden jump came as a one time effect from the first time consolidation of Thinksoft, whose share of revenues classified as RTS has been above the previous SQS ratio. Our strategy continues to be to reduce the share of this segment of our total revenue below 30%, which is evidenced by the ongoing reduction of our total client number to 423 (H1: 460), despite additional c. 50 clients from Thinksoft during the first half.

Other

Revenue in the Other segment amounted to €11.5m in the period (H1 2013: €9.0m), an increase of 26.7%. Revenues growth from tool licence sales (SQS own and third party tool re-selling) and contractors were the key drivers of this increase.

Margins and Profitability

Adjusted Gross profit* improved by 28.7% to €42.8m (H1 2013: €33.2m), with the gross margin at 33.1% (H1 2013: 30.8%). The increase in the gross margin was mainly influenced by a higher share and an improved gross margin from managed services contracts with a gross margin of 35.7% (H1 2013: 33.2%) due to a growing proportion of contracts now delivered in a global delivery mode utilizing more the SQS near- and offshore test centres.

Gross margins from SCS were 32.8% (H1 2013: 34.0%) and RTS 33.6% (H1 2013: 29.7%) reflecting the reclassification of one major banking client from SCS to Managed Services and a first time consolidation effect from Thinksoft in RTS.

Gross margins in Other were practically unchanged at 18.2% (H1 2013: 18.4%).

Adjusted** profit before tax for the period was €8.5m (H1 2013: €4.5m), an increase of 86.7%, with the adjusted profit margin rising to 6.6% (H1 2012: 4.2%). The profit before taxes benefitted from the strong gross margin improvement and slightly reduced overhead costs as a percentage of revenue.

Adjusted*** earnings per share increased to €0.18 (H1 2013: €0.12).

* adjusted to add back €1.0m of IFRS amortization of order backlog from Thinksoft (now SQS India BFSI) acquisition

** adjusted to add back effect under * and €2.6m of IFRS amortization of client relationship assets from Thinksoft (now SQS India BFSI) acquisition, €0.6m of non-recurring severance costs for the Thinksoft founders and €0.2m acquisition costs for Thinksoft

*** adjusted to add back effect under ** and €0.4m of pro forma IFRS forex adjustments of Thinksoft acquisition value, at actual local GAAP tax rate of 29%, less €0.6m on minority interests

Costs

General & Administrative expenses (before effects under ** above) for the period were €22.1m (H1 2013: €18.6m). While coming down 0.1% as a percentage of revenue to 17.1%, the absolute growth was mainly due to a first time consolidation effect of Thinksoft (€3.1m) and on-going investment in the US business (€0.4m).

Sales & Marketing costs for the period were €10.1m (H1 2013: €8.3m), representing 7.8% of sales (H1 2013: 7.7%). The absolute increase mainly came from the first time consolidation of Thinksoft (€1.0m).

Research & Development expense during the period was flat at €1.4m (H1 2013: €1.4m) representing 1.1% (H1 2013: 1.3%) of revenues. Research and development investment was mainly focused on the development of software testing tools and our proprietary PractiQ methodology.

Cash Flow and Financing

Cash flow from operating activities was lower at €-2.6m (H1 2013: €4.4m). The focus on fewer and larger managed services clients has resulted in a seasonal increase of receivables and work in progress of €14.3m over H1 2013, resulting in a temporary impact on our operating cash flow. This increase includes a €7.6m effect from the first time consolidation of Thinksoft receivables. We have generally seen this increase of receivables and work in progress in all previous years during the first half, and are confident that there is no risk on either invoicing or collecting these amounts. We therefore expect an improved cash collection and full profit to cash conversion during the second half of the year.

Debtor days (incl. work in progress) increased to 82 (H1 2013: 76), mainly resulting from the first time consolidation of Thinksoft receivables, whose debtor days were at 110.

Cash inflow from investments increased to €4.0m (H1 2013 €2.5m outflow) mainly due to an exceptional first time consolidation effect of Thinksoft with an acquired cash position of €7.3m. Investment in the third phase in our building for our India (Pune) based offshore test centre continued, increasing the cash outflow for fixed and intangible assets to €3.6m (H1 2013 €2.5m outflow).

Total cash outflow from financing activities was €3.3m (H1 2013: 4.7m outflow) reflecting a net increase of finance loans (including leasing contracts) of €5.9m as cash reserves are increasingly held in a higher diversity of currencies and offset between cash positions and debt positions has become less flexible as we seek to exclude potential exchange rate loss risks.

Balance Sheet

We closed the period with €17.0m (30 June 2013: €7.0m) of cash on the balance sheet and borrowings of €25.9m (30 June 2013: €17.3m). While the first time consolidation of Thinksoft led to a one time increase of the cash position of €7.3m (with certain legal restrictions to transfer these funds), cash reserves are increasingly held in a higher diversity of currencies and offset between cash positions and debt positions has become less flexible as we seek to exclude potential exchange rate loss risks.

The resulting net debt position at the period end was therefore €8.9m (30 June 2013: €10.3m).

Due to the purchase price allocation with regard to the Thinksoft acquisition, intangible assets with a fair value of €21.4m have been identified and recorded within the balance sheet. Of the said €21.4m, €3.9m have been allocated to goodwill, €15.6m have been allocated to client relations and €1.9m to the acquired order backlog. Client relations are amortised over a three year period with €2.6m amortization in the first half, while order backlog will be amortised over a 12 months period with €1.0m amortization in the reporting period. These amortizations are non-cash-items. As they do not impact the normal business of SQS they are adjusted within the PBT und EPS reporting. 

Taxation

The tax charge of €1.1m (H1 2013: €1.3m) includes current tax expenses of €2.5m (H1 2013: €1.2m) and deferred tax expenses of €-1.4m (H1 2013: €0.1m). The tax rate on local GAAP results was 29% (H1 2013: 26%). For the full year, we expect an actual tax rate of 30%.

Foreign Exchange

Approximately 53% (H1 2013: 57%) of the Group's turnover is generated in Euros. For the conversion of revenues and costs generated in local currencies into Euros, the relevant official average exchange rate for the six-month-period of 2014 was chosen. For the conversion of the balance sheet items from local currency into Euros, the official exchange rate as at 30 June 2014 was used.

Foreign exchange had a small €0.1m negative translational impact on earnings for the period. Had the Pound/Swiss Franc/Indian Rupee/Swedish Krona/US-$/Euro exchange rates remained the same as in H1 2013, our non-Euro revenues for the period would have been €0.4m higher, resulting in an increase in PBT of €0.1m.

International Financial Reporting Standards (IFRS)

The Interim Consolidated Financial Statements of SQS and its subsidiary companies ("SQS Group") are prepared in conformity with all IFRS (International Financial Reporting Standards, formerly International Accounting Standards) and Interpretations of the IASB (International Accounting Standards Board) which are mandatory at 30 June 2014, whereas the interim reports are published in an abbreviated form according to IAS 34. The Interim Consolidated Financial Statements have neither been audited nor reviewed.

The SQS Group Consolidated Financial Statements for the six month period ended 30 June 2014 were prepared in accordance with uniform accounting and valuation principles in Euros.

Rene Gawron, Chief Financial Officer

3 September 2014

Notes to the interim consolidated financial statements (unaudited)

at 30 June 2014