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Morningstar | Charter Hall Education Trust Provides Further Evidence of Strengthening Childcare Sector. See Updated Analyst Note from 13 Feb 2019

Charter Hall Education Trust’s first-half results and fiscal 2019 distribution guidance of AUD 0.16 per unit were in line with our expectations. We maintain our earnings forecasts but increase our fair value estimate by 4% to AUD 3.34 to reflect the time value of money impact on our financial model. At the current market price of AUD 3.29 per unit, Charter Hall Education remains fairly valued. The market price implies a fiscal 2019 distribution yield of 4.9% versus 4.8% at our fair value and distributions are unfranked.

The key takeaway from the first-half results was management’s positivity regarding the outlook for childcare demand and supply. Both childcare centre operators and their landlords have been highlighting an increasingly difficult environment for childcare centre developers for about a year. However, Charter Hall provided further evidence with its result including a chart of the sharp decline in new centre openings in recent months. This supports previous claims that development activity has been impacted by a combination of a tighter bank lending following the Royal Commission into the financial services sector, more scrutiny of new developments by local councils, and more caution from childcare centre operators. In addition, new childcare centres appear to be opening where demand is high and child to place ratios exceed 3:1.

In addition to lower supply, management also claims the introduction of the childcare subsidy, or CCS, in July 2018 is having a greater positive impact on the sector than previously expected. The net effect is that re-enrolments in 2019 indicate an average 2 to 3 percentage point increase in childcare centre occupancy rates. This is a material increase that should have a positive impact on childcare centre profitability but is largely in line with our investment thesis, detailed in our February 2018 report: "How to Play the Childcare Bonanza."

Although Charter Hall’s statutory NPAT fell by 24%, this was mainly due to non-cash property revaluations that were less positive during the half than in the prior comparable period. We’re not concerned about this weakness as revaluations are non-cash, centre capitalisation rates had been pushed to extreme levels, and capitalisation rates have a degree of volatility in the short term anyway. We don’t expect price weakness to materially impact the company from a balance sheet, gearing, or debt covenant perspective.

Generally speaking, Charter Hall Education Trust remains in good shape with an occupancy rate of close to 100%. The firm's weighted average lease expiry increased to 9.5 years, versus 9.2 years in the prior corresponding period. Lease expiries before fiscal 2021 are negligible, with the largest proportion of lease expiries is between fiscal 2025 and fiscal 2028, representing approximately 50% of the portfolio by rent. We forecast rental revenue growth of 4% over the next decade, driven by 2.5% like-for-like rental growth, and further portfolio growth from developments and acquisitions.

Management continues to reposition the portfolio toward higher-quality and slightly larger metropolis-based centres. In first half fiscal 2019, this involved selling four centres in total worth AUD 4 million; acquiring one centre worth AUD 6 million; and developing three centres worth AUD 15 million. On a net basis, this increased the value of the portfolio by AUD 17 million or 2%. Gearing increased to just under 30%, from 29% in June 2018, net debt increased 8% over the half to a record high of AUD 321 million.

Charter Hall’s balance sheet remains in good shape with gearing (net debt/net debt plus equity) of just 30%, at the bottom end of management’s long-term target range of 30% to 40%. We are confident this level of gearing means the trust is well placed to weather a material decline in property values without breaching covenants, including a loan/value ratio of 50% and interest coverage ratio of 2.0. The trust also has additional protection in the form of interest rate hedges across 52% of its borrowings that should provide protection against short-term interest rate volatility.