EUR 850.00 For Business Accounts Only

Morningstar | Child Care Sector Still Attractive but Further Improvement Dependent on Occupancy Growth

Child care stocks have performed well in recent months, but the February 2019 reporting season needs to provide further evidence of improvement in child care centre occupancy rates to support higher share prices. The share price rally that began last November was triggered by evidence that the oversupply of child care centres was finally abating and being offset by increased demand due to the introduction of the Child Care Subsidy, or CCS, in July last year. This turnaround is in line with our investment thesis detailed in our January 2018 report “How to Play the Child Care Bonanza,” which assumes the CCS will ultimately boost demand and child care centre occupancy rates. The key risk to our thesis is that the sector could remain oversupplied as child care centre operators lack economic moats to prevent new competitors from entering the market.

From the perspective of the child care REITs, including Arena REIT and Charter Hall Education Trust, our thesis is playing out well. We consistently believed the securities of both trusts were undervalued over the past couple of years, as concerns about oversupply peaked. However, their security prices have rallied strongly in recent months and Arena now trades slightly above its AUD 2.50 fair value estimate and Charter Hall slightly below its AUD 3.20 fair value estimate. We don’t think either is significantly overvalued to justify selling just yet but a material increase in fair values is likely to require higher development activity which looks unlikely currently. The child care REITs trade on fiscal 2020 unfranked dividend yields of around 5.6%, which is in the middle of the range of the 25 real estate companies and trusts we cover. At fair value, we expect both trusts to deliver an annual total return of around 7%, which we consider a fair return for the investment risk.

Our expectation of occupancy rate improvement is based on the belief child care centre developers will act rationally and the CCS will result in much higher subsidies for families and boost child care demand. In 2018, child care centre operators and their landlords repeatedly claimed the supply of new child care centres was being curtailed due to tightening lending standards, following the Royal Commission into the financial services sector, and because lenders were concerned about the decrease in child care centre capitalisation rates and associated increase in investment risk.

We believe child care centre operator G8 Education has greater share price upside than the REITs from current levels. Operators’ earnings are far more leveraged to occupancy rates meaning further evidence of improvement will likely lift investor sentiment and help close the gap between G8 Education’s AUD 3.07 share price and its AUD 3.50 fair value estimate. We also think G8 has upside from the improvement in its board of directors, executive team, and corporate culture that’s occurred over the past couple of years. As explained in our note following the inaugural investor day last November, we are encouraged by the strategy and initiatives, such as the national call centre and brand consolidation, which could help improve margins and the competitive position over and above our current assumptions.

Despite the 21% fall in G8’s EBIT in the first-half, to June 2018, we expect second-half EBIT growth of 3% and a full-year EBIT decline of 7%. This is partly due to the second-half seasonal earnings skew but also because the first-half was impacted by the tail-end of the previous subsidy regime and associated funding problems that faced parents. The second-half captures the introduction of the CCS in addition to the opening of new centres. Our 2018 EBIT forecast of AUD 140 million is at the top end of management guidance provided last November, of AUD 136 to 139 million. We expect benefits of the CCS to increase in 2019 as the scheme experienced teething issues for the first month or two following its implementation. Our fair value implies a fiscal 2019 dividend yield of 4.6% or 6.5% including franking credits.

Although the national vacancy rate for long day care centres increased from around 9% in 2012 to around 20% currently, G8 has done well to defend its high teens margins which we consider to be sustainable. As the second-largest provider of child care services in Australia, G8 is well placed to extract economies of scale from further industry consolidation and build a national brand. It’s also less vulnerable than smaller players, such as Mayfield Childcare (ASX:MFD) and Think Childcare (ASX:TNK), to oversupply and which provide a degree of margin backstop. It’s also worth remembering only a few years ago, many areas experienced a shortage of child care places and long waiting lists which means "full" occupancy doesn’t necessarily mean a national occupancy rate of 100%, especially considering the extent with which demand and supply can vary between regions.

We continue to believe the child care sector has significant potential for further consolidation which we expect to be driven by increasing regulation and corporatisation. The sector’s somewhat patchy reputation was significantly impacted by the collapse of listed child care operator ABC Learning during the global financial crisis and the associated impact on landlords including Charter Hall. We expect this is partly why G8 has tended to trade at a price/earnings discount to the market despite delivering relatively strong earnings per share growth. However, we think the improvement in the quality of G8’s board of directors and executive team is a profound change which will gradually drive increasing confidence in the stock and the industry, over and above the cyclical improvement in occupancy rates. It’s also feasible the industry will increasingly be perceived as defensive and as "social infrastructure" which could justify a P/E premium, rather than discount, to the market.

We’re confident Federal government support for the sector will continue to grow. The Federal government’s support reduces customer credit risk and stabilises revenue growth for operators which further supports the "social infrastructure" description. The flip side to this benefit is it raises the prospect of a nationalisation of the sector, but we consider this unlikely for three reasons. First, a material proportion of child care operators are not-for-profit which undermines some of the justification for nationalisation; second, the productivity commission recommended keeping the current structure in its most recent review of the sector in 2015; and third, we expect the cost and complexity of nationalisation would likely deter all but a particularly left-wing Labor government. If anything, we expect both of the main political parties to continue to increase subsidies but that Labor will do so faster.