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New Labour has committed £30 billion to PFI and PPP projects, and many listed companies – with the support of their shareholders – are trying to get their hands on this cash. In an area not without risks and complexities, Ben Cobley debunks some myths and spots many companies set to thrive.

Whether you operate a back-street pub frequented by civil servants, sell software to help the NHS patients' records or run a cleaning business contracted by the government, the likelihood is that times are good right now.

The jury may be out on whether New Labour is delivering results with its long-hyped investment in our antiquated public services, but the money sure is going in.

Government spending is projected to rise from £418 billion in 2002-3 to £456 billion in the current tax year, facilitating extra investment in a range of areas, from large-scale capital projects like the London Underground to more up-to-date medical equipment for hospitals and educational aids for schools.

Amidst this mushrooming public expenditure, the private sector's role in the financing and actual provision of public services has become more and more pronounced. Indeed, this is probably now the most hotly-debated domestic issue in Britain today, drawing acres of media coverage, reams of reports and recommendations, plenty of criticism and no little vitriol, too.

But, despite the blocking tactics of a few, the increasing encroachment of private companies into previously public sector domains goes on unabated. New Labour is on probation to deliver and it is relying on private companies in large measure to carry out the task.

Whatever the rights or wrongs of this complex and often tiresomely-debated issue, from an investment perspective there is no doubt that there are significant opportunities to make money here, right across the spectrum.

The main reason is that New Labour has committed no less than £30 billion to private finance initiatives (PFI) and public- private partnerships (PPPs). That's £3 billion more than all of the PFI type initiatives undertaken since 1992, when John Major's Government first dreamed up the idea.

PFI and PPP contracts are constructed in a very complex manner (for details see page opposite) and involve all manner of trades and industries, from building roads and railways, to constructing – and then managing – hospitals, schools and social housing.

With so much money going in, its little wonder many listed companies are keen to get involved. Geoff Allum of broker Investec described the private sector's initial response to PPP and PFI as something akin to a new 'gold rush' in a recent 80-page report.

The biggest attraction for the companies – and investors – is that PFI and PPP contracts deliver the holy grail of business, namely long-term revenue and profit visibility.

The problem, however, as Allum is keen to point out, is that getting involved in these types of deals is fine if everything goes according to plan. But if and when events turn sour, those involved can face all manner of problems.

As an example Allum raises the spectre of National Physical Laboratory project, saying that 'whilst this has been a very successful project for both Serco and the SPV (Special Purpose Vehicle), it was highly costly to John Laing, the company which won the construction contract.'

The humiliating profit warnings from Amey and WS Atkins (both of which have since become bid targets) are other illustrations of what can go wrong. As a result, Allum says, companies with a large exposure to PFI contracts are now more lowly-rated than their support services sector peers, though there has since been some re-rating.

The market's concerns range from the substantial costs involved in bidding for work (effectively pricing many smaller companies out of the process) to wariness of the off-balance-sheet nature of SPVs (for details of these vehicles see box right).

Outside the nitty gritty of operational issues, there is concern that public and political opprobrium could kill future PFI projects, and even perhaps scupper present ones.

Study after study had concluded that there is insufficient data to make a judgement on whether PFI is delivering value for money.

PFI here to stay

However, in February, a National Audit Office report looking at 37 projects concluded that 'there is strong evidence that the PFI approach is bringing significant benefits to central government in terms of delivering built assets on time and for the price expected by the public sector.' It found that cost and time overruns had occurred on less than 25 per cent of projects, compared to more than 70 per cent of non-PFI contracts surveyed for a 1999 report.

In conclusion, Allum reckons that 'the PFI market is too important to ignore,' saying 'for a prudent company, the majority of PFI contracts offer good returns and a normal level of risk.'

Who to back?

Taking a punt on the PFI/PPP sector involves one core choice, namely whether to plump for the safer support services companies that manage the assets on long-term contracts after their completion, or to go for construction companies that, as Teather & Greenwood analyst David Taylor points out are 'inherently more risky'.

The issue is clouded by the diversification of many traditional construction companies, such as Kier and Mowlem, into the support services arena – mostly through acquisition. But this also presents opportunities, for these companies are typically more lowly rated than their support services counterparts.

Indeed, Taylor says of construction that 'you have to think in terms of the contractors – the ones that are big enough to be capable of doing growth bits like PFI and that are moving into support services.' He points out Carillion as such a company, adding that 'Kier comes out quite well and Morgan Sindall seems to have got its thing back on the road.' The latter has had a year or so of problems in its regional contracting subsidiaries, now remodelled into a single company called Bluestone. But it also has what Taylor calls 'two lungs of growth in social housing and infrastructure maintenance', both of them productive areas of activity at the moment.

There is also an interesting situation brewing at Galliford Try, a company now nearly three years into its post-merger period but still struggling with its contracting division, even though its regional housebuilding businesses have been going from strength to strength.

Of the bid speculation, Taylor adds that 'I'm quite serious that something is quite likely to happen unless construction is sorted out very quickly.' He reckons 'it is worth more in pieces than on its own', and sets a price target of 40p. Kier itself would look like a natural bidder, given the similar spread of its activities, but Taylor says that 'most of the things that one hears about are of a private equity nature.'

The company itself has denied it has been in talks, but, as Arbuthnot construction analyst Stephen Rawlinson points out, 'there is pressure to improve', adding that 'essentially the stock is a small, good housebuilder with a potentially improving construction arm for free.'

Rawlinson himself generally agrees with Taylor about the areas to look at in the area, saying that 'contractors and infrastructure support services show the best value', pointing to social housing specialist Connaught, Morgan Sindall and electrical engineering contractor T Clarke as his favoured picks.

In support services, the range of companies offering exposure is broad and varied. The likes of Enterprise, Mears and Mouchel may look a bit expensive at more than 13 times earnings, but they are growing quickly. Perhaps more enticingly, Interserve is much more lowly rated. Allum reckons that this company is well worth investing in, also noting that rail contractor Jarvis 'should be seen as attractive' once the uncertainties of Network Rail's 'radical new approach' become clearer. His top pick, though, is mid-cap Serco, due to 'the strong attractions offered by its high earnings visibility and growing market'.

Healthcare, IT and education

But extra investment in public services is not being restricted to capital projects – far from it. Government health spending, for example, is earmarked to increase by more than seven per cent per year over the next five years, expressly including 'significant' spending on IT and equipment. Ian Spence of broker Baird says that '2003 is shaping up to be a strong year across all parts of the public sector IT spectrum.' He adds that 'NHS procurement seems to be proceeding in a surprisingly efficient manner and local authorities seem to be getting to grips with the nuts and bolts of the transition to e-government.'

In the healthcare arena, two companies, healthcare software suppliers iSOFT and Torex, stand out. Both have been performing well and have recently claimed that trading remains strong. IT services group Detica is also enjoying the fruits of increased public spending, especially in the national security arena following 9/11. The company recently announced an excellent set of figures for the year to March, a period in which sales to the Government rose 40 per cent to £19.7 million, accounting for just over half of its turnover. Pre-tax profits surged 25 per cent to £7.4 million, right at the top of forecasts.

Online learning group Epic is also having a lot of success in winning public sector contracts, with half of its revenues coming from that area in the six months to last November. In education services, Nord Anglia and notably Tribal have done well, though both are already highly rated by the market.

In healthcare services, Care UK looks well set to benefit from the UK's ageing population due to its focus on outsourced care services from local authorities and social services. Highly profitable support and personnel business Nestor Healthcare looks reasonably attractive, even though this year is expected to be relatively disappointing. Finally, hospital support group Synergy Healthcare is growing profits rapidly and looks a decent long-term punt.

PFI and PPP – the rules and the risks

To meet these terms the SPV contracts out the construction and maintenance of the assets in question – with each member of the consortium likely to get a substantial workload. If the terms of the contract with the public sector procurer are breached, the SPV is liable to have fees deducted and pass these costs on to the individual contractors responsible for that part.