We recently talked to Diederik Vos and René Gawron, respectively CEO and CFO of SQS, to reflect on SQS’ financial H1 2016 performance and on strategic initiatives.

Service Mix Transformation Impacts Revenue Growth in H1 2016

On the surface, the performance of SQS in H1 2016 was mixed: revenues were up 10.9% y/y but flat at constant currency/perimeter (CC/CP); and an adjusted PBT margin was up 110 bps y/y, to 7.1%. Beneath these numbers, there are a number of factors at play.

CC/CP Growth to Resume in H1 2017

SQS continues to realign its Professional Services (PS, formerly Regular Testing Services, its staff augmentation unit) towards larger and more profitable contracts, reducing the number of contracts and redeploying personnel. In the short term, this is impacting revenues of Professional Services, which were down 3% in H1. The good news is that SQS believes the PS realignment is coming to an end: PS accounted for 29% of revenues in H1 2016, and is now in line with SQS’ long-term goal to ~30%. SQS should be back to CC/CP growth in H1 2017.

SQS is also benefiting from inorganic growth: acquisitions in 2015 included Galmont Consulting and Trisential in the U.S. and Bit Media in Italy. These acquisitions, the ~€10m acquisition of the final 25% stake in its Pune operations, also cash flow seasonality in Europe, have meant an increase in SQS’ net debt, up from €5.9m at end 2015 to €32.9m at end H1 2016. Management expects net debt will be closer to ~€13m by end 2016, and well under control. SQS is putting on a pause on larger acquisitions for now.

SQS’ Profitability Will Increase Thanks to its Service Mix Change

The improvement of its adjusted PBT margin improvement remains a priority: some of this improvement will come mechanically from a full year benefit of recent acquisitions.

Also:

• SQS expects gross margins in its PS unit will improve from the current 27% level, due to its stronger focus on fewer, larger contracts
• SQS is growing its higher margin services: Managed Services (now called Industrial Managed Services, IMS) has a gross margin of 36%, flat over y/y. Management Consulting currently has gross margins of 34%, expected over time to expand to 37%.

Strategic Initiative One: Sustain Success in the U.S.

The U.S. is now SQS’ second largest geography (contributing 17% of revenues, ~€28m). Revenue growth of 310% in H1 2016 was obviously fueled by acquisition; we estimate CC/CP growth was also strong, at 15%-20%. SQS is integrating Galmont Consulting (now SQS North America), its “rural shore” business with an 80-FTE delivery center in Kentucky, with its global delivery network, aligned with its Indian operations. This remains a work in progress.

Strategic Initiative Two: Management Consulting

With Trissential (~€32m in revenues in 2015), SQS acquired a consulting firm with process engineering, project and program management capabilities, which it wants to maintain as an independent brand and grow from its Mid-West base (Minneapolis, Milwaukee and Chicago) and expertise in manufacturing and energy (and to a lower extent in retail, finance, and healthcare) towards Texas and the East Coast.

Trissential has the potential to drive important revenue synergies with SQS’ software testing capabilities by allowing SQS to be involved earlier in the testing decision lifecycle. This is something SQS also did back in 2007, when it acquired Triton, a boutique consultancy servicing the Austrian insurance sector.

Further investment by SQS around its consulting operations is likely: the company also wants to grow these services in the U.K., probably organically. Financial services is a likely vertical.

Bottom Line: SQS Continues to Impress with the Speed of its Transformation

SQS continues to impress us with the speed of its execution, its reinvention of the Indian delivery model, continued geographical expansion, and service portfolio transformation. So far, the financial performance of SQS has only partially reflected this transformation. In all likelihood, the effect of its reinvention on its financial performance will become more evident in CY 2017. We are already seeing the positive impact of SQS’ realignment of its India-listed subsidiary SQS India BFSI (formerly Thinksoft), whose revenues were up 25% in Q1 FY 2017.

Our next blog on SQS will focus on its functional and non-functional automation and service portfolio transformation effort and its focus on UX testing and crowd-testing.