Business Review

The electronic security and surveillance market is large, growing and in the process of fundamental structural change.

2008 Overview

Last year was a challenging year for the Group as we continued to grow the scale of our business and increased total sales by 20% to £79 million, with each division posting an increase in turnover over the previous year. Some of this increase related to low margin pass through sales in our security management activities but even after adjusting for this, the underlying top line sales growth was 12%.

Underlying profits fell back from last year’s record high to £3.7 million (2007: £5.3 million) due to a number of factors. Some of these were internal and related to higher than anticipated costs to complete important contracts in our hazardous area and defence surveillance operations, but we were also affected by higher than expected raw material costs, particularly for stainless steel, used in our camera stations for hazardous area surveillance projects which were bid on fixed-price long-term programmes with limited pricing flexibility.

The performance of our two divisions, Quadrant Security and Synectics, is reviewed in more detail below:

Quadrant Security

The Group’s security services division, providing integrated security systems, security management support and mobile surveillance services.

Turnover	£58 million
Underlying Operating Profit	£3.5 million

Quadrant Security Group (“Quadrant”) achieved an overall increase of 24% in turnover for the year to £57.9 million (2007: £46.6 million). Of this growth, around half came from the increase in pass-through turnover mentioned above, so a fairer measure of actual achieved growth would show an increase of 12%. Although operating profits from the division declined from £4.2 million to £3.5 million, this reduction was entirely due to the previously flagged expected decline in profits from the run-off of old contracts within the security management activities. The overall result for the division was in line with the Board’s expectations for the year.

As reported at the interim stage, the UK systems integration activities suffered in the first half from delays in award of central government contracts in the high security area. This effect was largely reversed in the second half, with resulting much improved turnover and profit levels compared with both the first half and the second half of the prior year.

Of particular note was the good progress made in our on-vehicle CCTV activities, which enjoyed a strong year in almost all aspects of its operations. In July we announced we had signed a new £1.5 million contract for the supply, installation and maintenance of CCTV on Stagecoach’s new buses. The 12-month deal will ensure all new buses ordered by Stagecoach in 2008/9 are fitted with state-of-the-art digital CCTV systems from Look CCTV, a subsidiary of Quadnetics.

Contributions from our Middle East activities were well below our expectations in 2007/8 with sales being 37% below last year’s levels, despite very high levels of pre-sales activity and investment in establishing a limited liability subsidiary within the Kingdom of Saudi Arabia and obtaining the necessary official commercial registration. We have now reorganised our activities in this area to create a stronger ‘Quadnetics’ regional focus in order to more rapidly achieve critical mass. We are pleased to report that the long-awaited contracts are now coming through to protect critical national infrastructure in Saudi Arabia and Jordan and there is an increasing level of activity in other countries in the region.

Our Managed Service business, SSS, is predominantly focused on the UK retail market and although it benefits from fairly long-term contracts and relationships, it is not immune from the economic downturn in this sector. During the year we had planned to move to a higher margin business model where SSS would provide more comprehensive outsourced security management services to multi-site retail clients. However, whilst we continue to believe there is good future potential in this area, particularly in its ability to generate contracted recurring revenues, we have delayed planned investments in systems and personnel until we see signs of recovery in this sector.

Synectics

The Group’s security technology division, providing security network products and software, hazardous area systems and defence surveillance technology.

Turnover	£23 million
Underlying Operating Profit	£1.6 million

Synectics’ turnover for the year grew by 11% to £23.1 million (2007: £20.8 million), the most positive component of which was continued growth of network products and software in the North American gaming surveillance market where turnover grew by 27%. With new products starting to come on stream and the interest in our Synergy software as a potential stand-alone product, we can continue to build in this territory over the next few years. In the core security network products and software area overall, average gross margins increased notably, though overhead cost increases associated with the new products restricted the relative bottom line growth.

As previously announced in May, problems with two large contracts in the hazardous area and defence surveillance activities, and related knock-on operational effects, had a significant impact on the Synectics division expected profit. Although turnover from those areas rose, their combined contribution to operating profits was around £1.1 million lower than in the prior year.

Management changes have been made and process improvements implemented in both areas. The two contracts, which nevertheless have been profitable, are now close to finalisation and are not anticipated to have any further negative impacts. The defence surveillance sector generally, though, continues to be adversely affected by customer budget constraints and contract award delays.

As digital surveillance and IP systems have become more widely accepted, margins on our broadcast TV quality MPEG2 solutions came under pressure from competitors with lower cost or generic PC-based systems, often using alternative or proprietary encoding platforms. Our strategy was to retain the accepted industry standard MPEG2 whilst developing the next generation H.264 platform, effectively bypassing MJPEG, Wavelet and MPEG4. Our whole product portfolio was successfully transitioned to H.264 within the year and these products are now selling well and include, for the first time in our product line-up, an edge-based multi-stream encoder which also has a dedicated Digital Signal Processor (DSP) capable of running real time Video Content Analysis (VCA).

The H.264 platform offers significant image quality improvement at lower bit rates than alternative formats and this has the benefit of using lower bandwidth for transmission over networks and requires less storage for recording and evidential purposes. We believe that H.264 will be a stable, long-term encoding technology with a road map stretching ahead for several years, including high definition capability for the next generation of megapixel cameras.

Towards the end of the year, Synectics launched its important new range of H.264 digital video products, benefiting from investment in research and development costs capitalised in the year. This level of capitalised investment will reduce in the current year. Deliveries of Synectics’ mobile video recorder will begin shortly, following recent completion of successful trials, and they have already received an enthusiastic response from existing and potential new customers. The manufacture of these products will be largely subcontracted. We are currently finalising manufacturing agreements to ensure that we successfully achieve the benefits of high quality, higher volume manufacture as sales growth feeds through.

Synectics have provided a comprehensive surveillance control solution to Royal Holloway, University of London. 

Markets

Our core markets are currently continuing to enjoy growth although looking forward, this view must be tempered by the general economic conditions, particularly in our largest markets in the UK and North America. The security market has historically been fairly resilient to changing market conditions, in part due to the ever increasing need for security and protection but also due to the performance and cost advantages that networked security solutions can deliver. These are real and valuable to all sorts of organisations as they strive to reduce operating costs at the same time as improve service levels to their own customers.

Despite the reduction in sales into the Middle East, Quadnetics continues to expand into other territories and our overseas sales grew by 13% to around £13 million in 2008. We expect this trend to continue.

Sales around the world have been as follows:

• North America: +31%
  Our enterprise solution continues to be selected as the product of choice in many casino chains, with approximately $12 million of sales to the gaming sector in the year and almost $9 million of further commitments to our technology in the pipeline.
• Asia Pacific: +23%
  Sales of our EX explosion rated, marine and hazardous area surveillance products into the Far East continued to grow above the record levels of last year.
• Middle East: (37%)
  During the year sales declined in the Middle East owing to structural changes in the way our business could be done in the region, but we have now established a subsidiary company operating in the Kingdom of Saudi Arabia, and are at an advanced stage of negotiating partnerships in Jordan to complement our existing sales office in Dubai.
• UK and Rest of World: +21%
  With almost £70 million of sales into the UK (and other regions excluding those above), Quadnetics is a sizeable business with an estimated addressable UK market share of around 10%. The majority of our 450 people are based in the UK, where we are recognised as one of the leaders in the marketplace for both technical capability and quality of service.

Quadnetics is consistently beating competitors by demonstrating the value and strength of its products and services. With new edgebased devices and analytic software coming to market shortly, we expect to be opening up new channels to fuel continuing growth for the next few years. We are constantly looking for ways to develop and improve our products and services to take advantage of our strengths in these times of significant change.

Synectics provides long-range camera technology around the world. 

Quality, Environment, Health & Safety

Whilst we have scaled back our planned investments in upgrading some of our management information systems for the time being, we have continued to invest in the recruitment, development and training of our people to make sure that we continue to raise the bar competitively by providing best in class products, support and service.

Throughout the year we have continued our long-standing arrangements with external consultants and advisers to ensure that our health and safety practices and policies are appropriate and up to date. We have also revised our personnel handbook, which is issued to all UK employees, explaining how the Group operates and setting out our policies and attitudes in the important areas of quality, the environment, ethical practices, and health and safety.

Quadnetics currently operates multiple ISO 9001:2000 Quality Management Systems, rather than a single system due to the wide range of activities involved in the design, development and manufacture of physical products and software.

During the year we were proud to announce that Quadrant achieved registration to the National Security Inspectorate (NSI) Silver scheme in CCTV, access control and intruder alarms for all sites, complementing the NSI Gold registration already in place within SSS, our Managed Services business. We are also pleased to have achieved accreditation to the environmental management standards of ISO14001:2004.

Finally, as part of our continuous risk assessment and review programme, we have developed and introduced business continuity plans that should enable the business to recover quickly in the
unlikely event of a major incident.

Research & Development

We continue to invest in the Group’s future through our research and development activities with £2.0 million invested over the last year to bring to market new or enhanced products. Our twin-track approach to managing R&D involves a simultaneous project and product focus which sets Quadnetics apart from most of its rivals and makes the Group very responsive to changing technology and changing customer needs.

Project Focus

The project focus allows many developments to be funded externally, by aligning the target product with the requirement of a contract with an end user. This has historically led to successful projects being completed on time, on budget, with new products emerging as a result. One of the drawbacks to this method is that it is not always possible to adhere to a development road map programme due to urgent customer issues that might arise during the contract.

Product Focus

In contrast our product development team are insulated from day-to-day customer issues and as a result are able to work in a predictive manner, bringing new products to life and maintaining a life-cycle road map.

A great deal of ground-breaking research and development has been carried out and patents have been filed to protect our valuable intellectual property. Our goal was to design the next generation ultra-reliable H.264 based “black-box” recorder for mobile applications and whilst the product has taken longer and cost more to develop than originally anticipated, we have created what appears to be a truly world-class product that is creating a lot of interest both in the UK and overseas. We are currently finalising a Low Cost Region supply chain to produce high quality products in significantly higher volumes, and at lower cost than we could achieve by UK or European based manufacture.

New products are being developed at Synectics' Research Centre.

Group results for the year
Income statement

Overall revenue in the year amounted to £79.2 million compared with £66.1 million in 2007, an increase of 20%, although approximately £6 million of this arose from additional low margin pass-through sales from Quadrant’s management services business. Quadrant’s sales were £57.9 million, up 24%. Excluding the additional pass-through sales, Quadrant’s sales grew by 12%, boosted by some large contracts for the high security sector. This compares with a growth rate of 11% (to £23.1 million) at Synectics, where the US business increased its sales to the North American gaming sector by 27%.

Overall reported gross margins fell from 33% to 27%, although this reduction is distorted by the increase in low margin pass-through sales noted above and reduced benefit from the close-out of old contracts in the managed services business, and the reclassification of £0.6 million of labour costs previously included in overheads.

The underlying decline in gross margins, excluding those factors, was 2.2%, primarily resulting from the cost over-runs on contracts in the defence and hazardous area sectors.

Underlying margins, before reclassification of direct labour costs, in the Look mobile CCTV business and the Security Networks’ activities improved during the year.

Operating expenses include both share-based payment costs and goodwill reduction charges, as follows:

	2008 £’000	2007 £’000
Total operating expenses	17,147	17,651
Less goodwill reduction charge	(141)	(309)
Add/(less) share-based payments credit/(charge)	805	(595)
Underlying operating expenses	17,811	16,747

Adjusting for these items, underlying operating expenses have increased by 6.3% from £16.7 million to £17.8 million largely as a result of increased investment in sales and marketing (£0.6 million) both in the managed services business and Synectics; service and installation personnel (£0.2 million); and development expenditure (£0.1 million).

The largest of the Group’s share schemes, The Quadnetics Group Employee Share Scheme, is considered to be a cash settled scheme under IFRS 2: Share-Based Payment, and therefore the fair value of the scheme benefits is assessed at each period end. Based on the Company’s share price at 31 May 2008 previous sharebased payment charges have been reversed resulting in an overall credit of £0.8 million to the Income Statement.

In addition, the Income Statement has been charged with £0.1 million (2007: £0.3 million) in respect of goodwill reduction relating to tax losses. This arises as a result of the recognition of tax losses that existed within the Protec Group at the time of its acquisition in November 2005, but which were not included in the acquisition balance sheet and therefore the valuation of goodwill at that time.

Net finance income arising from interest on cash balances placed on deposit with major UK banks amounted to £0.2 million, a similar level to 2007.

Underlying profit before tax, being profit before tax, share-based payments charge and goodwill reduction, was £3.7 million and compares with £5.3 million in 2007.

The tax charge for 2008 was £1.0 million compared with £1.1 million in 2007. The underlying tax rate (being the percentage ratio of the tax charge for the year, after adding back the tax effect of share-based payments, to the underlying profit before tax, goodwill reduction and share-based payments) was 21%, compared with 24% in 2007.

The 2008 tax charge continued to benefit from the utilisation of brought forward tax losses which had not previously been recognised in the profit and loss account, and in addition from backdated claims for additional relief on research and development expenditure. At 31 May 2008 the Group had carried forward tax losses of £1.3 million in total, all of which have now been recognised in the profit and loss account.

Profit after tax was £3.4 million compared with £3.3 million in 2007.

Basic earnings per share were 21.6p (2007: 21.1p). However, these calculations are significantly influenced by the £1.4 million swing on the share-based payment charge year on year, and the underlying earnings per share, based on profit after tax but before share-based payments (net of any tax effect) and goodwill reduction was 18.9p (2007: 25.9p).

SynergyPro control software is Synectics' flagship software product. 

Balance sheet

Major movements on balance sheet items were as follows:

Property, plant and equipment increased by £0.4 million in the year primarily as a result of expenditure on leasehold improvements and office furniture and equipment at Synectics’ new office building in Sheffield, acquired in 2007, which was sold for around its original cost price of £2.1 million and then leased back during the year.

During the year costs of £1.1 million incurred on product development mainly in respect of our new mobile recorder unit, were capitalised thus increasing Intangible assets by this amount. Sales of our new E100 digital encoder technology commenced towards the end of the financial year and therefore capitalised costs in respect of this product began to be amortised.

Working capital balances (excluding cash balances, property for resale and provisions for share-based payment liabilities) were at a similar level to those at 31 May 2007, with increases in trade receivables as a result of high activity levels in the last quarter, being matched by corresponding increases in trade payables and accruals.

Non-current provisions reduced by £0.3 million at 31 May 2008 as a result of the next deferred consideration payment in respect of the AlphaPoint acquisition in the United States falling due in 2008/9.

Consolidated net assets increased by £2.4 million to £32.8 million at 31 May 2008 (31 May 2007: £30.5 million), as a result of the profit after tax for the year of £3.4 million less dividends paid of £1.0 million.

Cash

The Group ended the year with cash balances of £7.9 million, following net cash inflows of £2.3 million during the year, compared with an opening balance at the start of the year of £5.6 million.

Cash generated from operations of £4.7 million was further boosted by the sales proceeds of the Sheffield property of £2.1 million noted above, and interest received of £0.2 million. Major cash outflows arose from expenditure of £1.1 million on fixed assets and software and a further £1.1 million on capitalised development expenditure. In addition, payments of £1.4 million and £1.0 million were made for taxation and dividends respectively.

Free cash flow, that is cash generated from operations less capital expenditure, was £2.5 million or 71% of underlying operating profit before tax. This figure reflects higher than usual expenditure on new product development.

The Group has no debt.

Key performance indicators

The Directors measure the Group’s performance, principally using the following financial indicators (as reflected and discussed in this Annual Report):

• Sales
• Gross profit percentage
• Underlying operating profit and underlying profit before tax (both profit measures being before goodwill reduction, share-based payments and exceptional items)
• Earnings per share
• Underlying earnings per share (based on underlying profit after tax)
• Order book
• Recurring revenue (being contracted sales where a service is delivered over a future time period, and revenues are recognised in the relevant future accounting periods)

Principal risks and uncertainties

The principal risks facing the Group include the following:

• Price and margin pressure

The electronic security industry in general is competitive with continued pressure on sales and margins. The Group’s strategy to counteract this is to continue to focus on customer sectors where
electronic security systems have a critical cost of failure, or an extreme environmental requirement, rather than the mass volume markets. In addition, we will maintain a core of increasingly software-based proprietary technology giving higher margin opportunities, and focus on developing recurring revenues.

• Technological risk

As the industry becomes increasingly technical and transitions to digital technology, there is a risk that products become obsolete or irrelevant. Quadnetics has countered this risk through its investment in research and development resources, and a continued focus on customer-led development to ensure that the most appropriate product development paths are followed.

• People skills and dependency

As with most businesses, particularly those operating in a technical field, we are dependent on our employees with key managerial, engineering and technical skills. The Group aims to offer appropriate compensation packages and incentive arrangements, as well as maintaining certain key-man insurance policies, in order to mitigate this risk.

• Impact of fluctuating currency exchange rates

The Group faces currency risk, both on transactions not undertaken in sterling, and on translation of the results of overseas operations, which it manages principally through forward exchange contracts. As the Group expands its sales and other activities outside the UK, these policies will be developed to manage the impact of currency variations.

Summary

Whilst we clearly did not get everything right last year as we continued our drive forwards taking market share from our competitors and establishing positions in our target customer sectors, some important and valuable lessons have been learned and we have made personnel changes and implemented more rigorous internal procedures.

All in all, we are making good progress and have produced a relatively solid underlying profit of £3.7 million; ended the year with £7.9 million cash in the bank; increased our recurring contracted revenue by 23%; and have designed new “world-class” products and software that should help us to maintain or lift our margins. We have also created valuable intellectual property to enable the Group to reach into other attractive economic regions by selling or licensing our technology to organisations and end-users in our target customer sectors.

The Oil & Gas industry uses Synectics advanced technology.

 

RC Singleton
Chief Executive

NC Poultney
Finance Director

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