EUR 850.00 For Business Accounts Only

Morningstar | Folkestone Education Remains Undervalued Following a Strong Fiscal 2018 Result

Folkestone Education reported a strong fiscal 2018 financial result that was broadly in line with our expectations. Our earnings forecasts are largely unchanged, and we retain our fair value estimate at AUD 3.20 per unit. At the current market price of AUD 2.71, we still believe Folkestone is undervalued. Based on the market price and our earnings forecasts, the fiscal 2019 price/earnings ratio is 15 and the distribution yield is 5.9%, whereas our fair value implies a P/E ratio of 19 and a distribution yield of 4.8%. Folkestone’s trust status means it does not pay corporate tax and its distributions are unfranked. Notably, Folkestone’s net tangible asset value per unit, or NTA, increased by 11% in fiscal 2018 to AUD 2.78, meaning the trust now trades at a discount to its NTA, which has rarely occurred in recent years.

Folkestone’s key performance indicators improved across the board in fiscal 2018. Aside from the 11% improvement in distributable income, the trust also increased its weighted average lease expiry, or WALE, to 9.9 from 9.1 years and its weighted average debt maturity to 5.0 from 3.5 years in fiscal 2017. We attribute these improvements in part to the management team but also to the underlying stability of the childcare sector, which is supported by growing federal government subsidies and the recently introduced Child Care Subsidy, or CCS.

We still believe that oversupply of childcare centres is a cyclical rather than structural problem, and one that was exacerbated by the subsidy caps under the previous childcare subsidy regime. We expect that the introduction of the CCS on July 2 has increased subsidies for the majority of families and that this will ultimately offset oversupply and drive stronger childcare centre occupancy rates and profit margins.

Management also remains relaxed about the short-term oversupply, which has caused concern among many investors over the past year, particularly as the trust lacks an economic moat. Management was reasonably vague with regard to the occupancy rates and profit margins of their tenants, but indicated that it isn’t noticing material industrywide issues.

Folkestone reported a 6.3% increase in distributions per unit, or DPU, to AUD 15.1 cents per unit in fiscal 2018 and expects a further 6% growth in fiscal 2019, which is in line with our forecasts. In fiscal 2018, growth was driven by an 11% increase in distributable income, offset by a reduction in the payout ratio due to the capitalisation of interest costs relating to development properties. The majority of the growth, or an 8% increase, came from acquisitions net of disposals, with a 4% increase due to organic rental increases and reflecting management’s strategy to move leases away from consumer-price-index-based escalators and towards fixed 3%-plus escalators.

Management continues to reposition the portfolio towards higher-quality and slightly larger metropolis-based centres. In fiscal 2018, this involved selling 19 centres, worth AUD 46 million; acquiring nine centres, worth AUD 63 million; and developing six centres, worth AUD 43 million. On a net basis, this increased the value of the portfolio by AUD 61 million, or 7%, meaning most of the DPU growth was effectively due to centre acquisitions and developments. This was possible because of the equity created by further declines in the portfolio capitalisation rate, to 6.3% from 6.7% in fiscal 2017, which caused a 15% increase in the value of the portfolio to AUD 973 million. Portfolio valuation growth enables increased borrowings, but although gearing only increased to 29% from 28%, net debt increased 21% to a record high of AUD 296 million.

Like most property companies, Folkestone has been the beneficiary of record low interest rates, both in terms of the ease with which it can access cheap debt and generate a profit margin from yield asset, and also via the associated decline in capitalisation rates and increase in property values, which creates equity against which it can borrow to fund portfolio expansion. It’s possible that a sustained increase in interest rates could reverse this trend, compressing profit margins and turning the trust into a forced seller of assets in a weak market. However, to reduce this risk, the company maintains gearing at a manageable level and hedges interest-rate exposure, with 56% hedged until fiscal 2023. We also expect long-term rental growth and inflation to create a natural deleveraging effect on the business. At this stage, we still believe Folkstone is sufficiently conservatively managed to weather an unlikely downturn in the childcare sector, and we remain comfortable with balance sheet gearing.