Don’t write off firms working with the public sector

The British Government and technology is a combination guaranteed to strike fear into the heart of any taxpayer.

Our politicians have a long and inglorious track record of failed projects and horrendous cost overruns; think of the Child Support Agency distribution problems, the tax credit overpayment fiasco, the DEFRA upgrade that left us unable to process EU subsidy payments to farmers, and the endless revelations about Home Office computer systems that appear to be held together by sticky tape. When we hear of another state-sponsored IT initiative, we roll our eyes and think "bang goes another ten billion".

Now the NHS has come up trumps again with its disastrous pick-a-cost-and-treble-it computer upgrade programme. The idea was that a new NHS computer system, backed by the Dear Leader no less, would allow electronic access to patient histories around Britain, making it easier to treat people in different locations around the country. It was an enormous undertaking, and the system was designed to hold the records of 30 million patients at a planned cost of £12bn.

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After various problems, it is more than two years behind schedule and the total cost might now top £30bn. What angers onlookers most is that this money comes directly from the Government's 1% increase on national insurance contributions, which was imposed in 2002 to pay for a better health service. The extra tax has been raising £8bn annually since its adoption in the 2002-2003 tax year, but instead of doing good, it now looks as if virtually the entire amount may be wasted on this white elephant.

Most of the headlines have centred on software provider iSoft, which was contracted to provide the systems for three of five regional software supply contracts in the modernisation programme. Delays in providing systems meant the firm pushed missing revenues into future years, leading to the discovery of accounting irregularities that are now under investigation by the Financial Services Authority. The company's shareprice has collapsed by 90% since the early days of the contract, with a profit of £5.9m being turned into a loss of £382m after enormous writedowns.

Looking back, the warning signs were there as soon as American IT giant IBM pulled out of the bidding for the contract because of the huge complexities involved. Among other things, it was unhappy with the Government's attempts to safeguard taxpayers' money by making the contractors absorb more of the cost overruns than in the past.

These fears proved well founded as the contract winners' have found; in addition to iSoft, US consulting group Accenture has put aside £240m against losses and is negotiating to quit the project.

Given the history of Government IT disasters and all the bad publicity they generate, it may sound like the kiss of death for a firm to get involved in one. But there are good opportunities in the public sector; widespread modernisation is needed and access to this steady, state-backed source of business will be very useful for companies if economies slow globally and less private-sector work is available.

The key is to target niche areas and companies that, unlike iSoft, are not biting off way more than they can chew. We look at three candidates below.

Three promising candidates for state-backed profits

Maxima (Aim: MXM, 156.5p) has two sides to its business: enterprise and document-management software, and managed services. Organic growth from the public sector and the financial services industry is buoyant: latest revenues were up 36% at £19m and the firm aims to reach £50m-£100m within three years. It bought four businesses in the year to May, for a total of £16.8m, and aims to do more deals this year. The shares trade on a p/e of 26, but fall to 6.9 on forecasts for year ending May 2007, cheap compared with the sector average of 15. The dividend yield is 2.6%.

Civica (Aim: CIV, 233p) is a provider of consulting, software and managed services to 90% of UK local authorities. The company develops software to process parking tickets and court cases, and has a contract with the Vehicle and Operator Services Agency to identify overloaded lorries. It recently bought Comino a firm specialising in software for local government, social housing and the occupational-pensions market for £50.1m. The shares trade at 11.8 times forecast earnings for year ending September 2006.

Detica (DCA, 302p) analyses data for Government and commercial clients to provide management and intelligence information. Last year, Government-derived revenues rose 49%, driven by strength in the defence and intelligence sectors. It recently made its biggest acquisition to date, paying £32m for management-consulting firm MA International. A strong growth outlook helps justify a p/e of 27 times forecast earnings for year ending March 2007.