Last week
The macro-economic surprise last week was on the upside as firm growth was reported in UK manufacturing for January and employment. The FTSE 100 improved 2% to 5997.4 with the FTSE 250 up 1% while the Aim All Share at 958.1 improved 1.5%.
This week
Thursday’s Bank of England interest rate decision is this week’s main event. The balance is changing as in last month’s meeting two members of the Monetary Policy Committee are now pushing for a rate rise. The consensus view remains no change—either to the 0.5% interest rate or the £200 billion asset purchase target. We forecast a cautious week reflecting international (Arab) uncertainties and expect the FTSE 100 to end the week lower.

Pause for thought
Fears of spreading  protests could disrupt oil shipments in the Suez Canal, which carries more than 4 million barrels a day.
Galleon (GON) – £4.4m at 2.63p
The shocking finals reported last week had to some extent been predicted by January’s trading update on lost contracts and that strategic repositioning necessitated the write down of goodwill. This multi-platform entertainment media company reported a £20.2m loss for the year to September 2010, with revenues falling 46%. The result was an operating loss before tax of £2.1m prior to adjusting for impairment of assets, provision against loans and receivables and share option charges totalling £18.2m.
Galleon is focused on its digital games and content publishing business in China and problems with the mobile market are resolved. The social games market is forecast to be worth $400m by 2013. In 2010 the infrastructure was developed to enable the publication of digital content across the internet and smartphones. This has involved recruiting and retraining staff, acquiring the necessary licenses and putting in place the marketing, billing and data capture procedures needed. Galleon has a joint venture with Chinese broadcaster Qinghai Satellite TV.Galleon’s knowledge of the Western and Chinese entertainment markets should help when pitching for licenses.   As well as publishing Chinese content growth prospects are enhanced by securing the rights to localising and publishing Western content in China. In the initial stages of the Smartphone “Apps” growth in China this could give a significant advantage due to the lack of Chinese specific content developed and ready for the marketplace. The launch of Galleons first exclusive online game in China in December 2010 is hoped to generate significant revenues going forward in this vast and growing market. Planned operating and head office cost reduction should ensure that there is sufficient working capital.
Despite the loss there was a cash inflow from operations. However, investment in intangible assets meant that there was a fall in net cash from £4.51m to £2.85m. The interims should show operating progress but it would be rash to predict a return to the 2009 level of £1m profits for the current year.
Maxima (MXM) – £26.8m at 106p
Revenues, from this IT services group fell from £26.2m to £23.7m in the six months to November 2010. Recurring revenues were steady at 61% of the total. The loss of the rights to sell QAD software knocked £2.5m from revenues. It also accounted for most of the decline in underlying profit from £2.6m to £2.3m as admin costs were reduced to bring them into line with the loss of QAD. There are still some small revenues coming through from QAD and one of the former QAD clients has employed Maxima to manage its IT systems. Although the business solutions division reported a decline in revenues it generated a greater profit because there were more software sales and fewer low margin hardware sales. A greater proportion of the development work is being undertaken in India. The services division has come under margin pressure as clients renegotiate renewal prices. Maxima believes that cloud computing and connectivity are among the areas that will provide the ongoing growth for the group. Maxima has 50 internet service provider customers and it expects to be able to sell other products to this customer base as well as other clients. An agreement with IBM to develop cloud services could prove significant. So far, it has required capital investment to develop a new platform. Maxima can offer Citrix virtualisation software and Microsoft Dynamics AX-related products. Both Citrix and Dynamics sales rose sharply in the first half of the financial year. Maxima is implementing Citrix software for Ryanair’s online booking system. Connectivity and network infrastructure business tends to involve larger contracts but lower margins. The Maxima brand in this area is Hotchilli. These growth areas will help to offset the steady decline in Maxima’s legacy business. Equity Development forecasts flat underlying pre-tax profit of £4.94m for the year to May 2011 which gives a prospective P/E of 7.6xand a maintained total dividend of 3p a share.

FinanceNet debt was £11.6m at the end of November 2010. The interim dividend is unchanged at 1p a share. Net debt is forecast to fall to £10.5m at the end of May 2011.

NWF (NWF) – £52.8m at112.5p
A strong performance from animal feeds offset tough trading for the food distribution business and enabled NWF to report higher interim profit. Revenues grew 16% to £203.4m in the six months to November 2010, while pre-tax profit improved from £2m to £2.2m.
Promotional activity by supermarkets complicated demand patterns and made them more variable for the food distribution business. This increased the cost of fulfilling orders hit the division’s profit. NWF believes that it can demonstrate these increased costs and ask for higher payments. Animal feeds had a strong first half with volumes 8% ahead and operating profit trebling to £1.5m. Raw material price increases have been passed on. Fuels revenues grew but profit was flat. The £3.3m acquisition of Evesons last month will enhance this division. NWF targets a 1p/litre profit on its fuel sales. If it can generate that figure from Evesons then its profit could improve from £100,000 to £800,000. That may take two or three years, though. The second half of the year tends to generate two-thirds of profit as fuel and animal feed demand increases in the winter. House broker Charles Stanley forecasts a profit of £6.3m for the year to May 2011, down from £7.1m in 2009-10 and put the company on a prospective P/E of 11.5x. The shortfall is mainly due to the food distribution business but fuels will also find it difficult to maintain the unusually high level of profit it achieved last year. Animal feeds is expected to improve its contribution.

Net debt was £17.1m at the end of November 2010. The interim dividend is unchanged at 1p a share but the final dividend is likely to be higher than the 3.3p a share paid last year.

Software Quality Systems (SQS) – £59.7m at 212.5p
SQS Software Quality Systems AG says 2010 revenues will be ahead of market expectations but it still needs to rebuild its margins. The Germany-based software testing company has been building up its managed services operations, which tend to make lower margins in the early days of the contracts. The attraction is that managed services business provides long-term visibility of revenues. The managed services order book is worth more than €50m with an average contract length of three years. The deferral of €500,000 of software tool sales also hit margins in 2010. That is why, despite the better than expected revenues, profit will be in line with forecasts. Revenues are estimated to be around €154m-€156m. That is higher than the previous peak of €142.9m in 2008. However, the forecast 2010 profit of €8.6m is well below the €13.1m profit achieved in 2008. The core German and UK markets are improving strongly but some of the smaller markets, such as Ireland, are still weak. There is pressure on pricing from competitors and this could continue to hold back margins. Moving more business offshore to India will help to offset the competitive pricing. Once the start-up costs of the managed services contracts are covered the margins on this business should improve.

SQS is the largest independent software testing company in the world. Software testing is the fastest-growing part of the IT sector. It is forecast to grow at 6%-9% a year, which is double the IT growth rate. The shares are trading on just over 9.1x times estimated 2010 earnings. There is a wide spread of profit forecasts for 2011. That is based on a recovery in gross margin from 31.5% to 33%, which is still well below the 35% level that has been approached in previous years. The forecast underlying operating margin of 7.1% compares with a peak of 9.4%. The 2010 figures will be released on 9 March.

A cash outflow is expected to push SQS into net debt at the end of 2010 but this should be reversed in 2011. There should also be scope for a recovery in the dividend next year. Assuming an unchanged dividend of €0.07 (5.9p) a share for 2010, the yield is 2.5%.

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