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Morningstar | Childcare Oversupply Affecting G8 Education More Than Expected; FVE Cut to AUD 3.50

We have cut our fair value estimate for no-moat-rated G8 Education by 12% to AUD 3.50 per share following the company's weaker-than-expected first-half result. The key challenge facing G8 continues to be the oversupply of childcare centres and resulting impact on centre occupancy rates, revenue, and profits. In the first half, the combination of occupancy weakness and negative operating leverage caused G8’s EBIT to fall 21% and EBIT margin to fall 4 percentage points to 12%. Although the business has a seasonal second-half earnings skew, which reduces the significance of the first half, we now expect full-year EBIT to fall 7% versus the prior year, down from our prior assumption of 1% growth. Our revised 2018 forecasts assume a 2.5-percentage-point fall in EBIT margin. Over the long term, we now assume a less pronounced recovery with an average EBIT margin of 18.3% over the next decade rather than our previous assumption of 20.7%.

Despite the fair value estimate cut, at the current market price of AUD 2.02, we continue to believe the shares are significantly undervalued, with the market price and our forecasts implying a fiscal 2019 price/earnings ratio of 10 versus 18 at our fair value estimate. Due to the tough operating environment, management brought forward the planned cut in the dividend payout ratio and we cut our fiscal 2018 dividend forecast by 30% accordingly. The payout ratio cut will be an unwelcome move for income investors but is prudent, considering the current competitive climate, and is in the long-term interests of the company. The current price implies a dividend yield of 8% or 11% including franking credits.

The weakness was affected by the inclusion of the final months of the federal government’s previous childcare subsidy scheme, which was replaced on July 2 with the more generous childcare subsidy. The first half therefore had the double impact of weaker demand from families who’d already hit their rebate caps and the new supply of childcare centres that hope to benefit from the childcare subsidy. We continue to believe that the first half is likely to be the earnings nadir for G8, on the basis that the rate of new centre additions appears to be subsiding and most families should now have higher rebates with which to pay for childcare. However, the timing of the improvement in the childcare market is uncertain with G8 expecting improvement in mid- to late 2019 but landlord Arena REIT claiming it’s already seeing the benefits of the childcare subsidy. Our forecasts assume gradual operating margin improvement from 2019.

It’s possible that G8’s margins will continue to compress beyond our forecasts, but we doubt the industry will be able to bear significant further margin compression. For example, the largest childcare group in Australia, charity-owned Goodstart Early Learning, which controls around 12% of the market, generated an underlying EBIT margin of just 3% in its fiscal year to June 2017. This means the company may need to raise fees, cut wages, or close centres to maintain its current financial position, which should support industry margins. Similarly, other listed childcare operators, including Mayfield Childcare and Think Childcare, lack the economies of scale of G8 Education, making it more difficult for them to withstand lower margins. Also, much of the industry comprises operators with only one or two centres, and we expect these providers to be particularly vulnerable to the recent margin headwinds.

G8 reported average like-for-like occupancy of 70% in the first half, down from 79% in the prior half and 73% in the prior comparable period. However, the company has changed the way in which it calculates occupancy several times in recent years, meaning the trend is of more use than the absolute reported figures. We previously assumed occupancy would bottom in 2018 ahead of the introduction of the childcare subsidy before gradually increasing over the subsequent two years, assumptions that we have maintained.

From a revenue perspective, G8 performed reasonably well in the first half. Organic revenue growth was flat, with occupancy weakness offset by price rises and new centre openings driving an 8% increase in group revenue. However, the lack of organic revenue growth coupled with rising employee costs and operating leverage caused a 17% fall in EBITDA that was amplified to 21% at the EBIT line, well below our forecast for 1% growth for the full year. The seasonal nature of the business means the majority of profits are generated in the second half, which reduces the margin and increases operating leverage in the first half. Over the past four years, the first-half EBIT has averaged 36% of the full-year figure, and management guided that the first half would constitute 34% in 2018, implying full-year EBIT of AUD 141 million, or 7% below our forecast before the result was announced but 1% above our revised forecast.

A positive aspect of the result was the refinancing of the AUD 270 million in Singapore dollar-denominated bonds and existing Australian dollar club facility with a new AUD 400 million syndicated bank facility. We expect the refinancing to reduce interest costs by around 200 basis points, which could save around AUD 5 million in interest costs per year. The refinancing also extends debt maturities by around 2.5 years. As at June 30, 2018, the net debt/EBITDA ratio was 2.0 and EBITDA/net interest ratio of 5.7. Although these metrics are comfortable currently and our base case assumes they will improve, a continuation of the first-half earnings weakness could quickly make them stretched.

Considering G8’s first-half earnings performance and the associated share price fall, we now think it’s highly unlikely that the company will acquire Affinity Education, despite reports that it has been involved in the sales process, as an equity raise at current prices would be unlikely and more debt is also unlikely.