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Morningstar | G8 Education Growing Up Quickly but Remains Undervalued

The key takeaway from G8 Education's inaugural investor day was that the company is maturing into a well-run business, which is improving its long-term prospects. Before Gary Carroll was appointed CEO in December 2016, G8 pursued an aggressive, debt-fueled acquisition strategy with little regard for synergies, organic growth, or the long-term viability of the company. Critics rightly drew parallels with the collapse of ABC Learning, but a lot has improved over the past two years, not least management access and transparency, and comparisons are no longer fair.

Carroll's careful appointment of a much-needed executive team appears to have gone unnoticed by the market. The head office now coordinates a national and customer-centric service business rather than a private equity style roll-up. Relatively new general managers of operations, marketing, and property are gradually transforming a disparate collection of childcare centers into a cohesive early learning services company. A general manager of learning will be appointed in the New year, which will help improve the quality of childcare services provided.

We aren’t concerned about the small 2018 earnings guidance downgrade as we believe the company is heading in the right direction and occupancy rates appear to have bottomed. We were encouraged by future plans including the launch of a national call centre in early 2019, likely national brand, and the strategy to improve occupancy rates irrespective of cyclical industry supply. We have maintained our AUD 140 million 2018 EBIT forecast and fair value estimate at AUD 3.50 per share. At the current market price of AUD 2.81, we continue to believe the shares are undervalued.

We are not concerned by the 2018 earnings downgrade that accompanied the investor day, from AUD 140 million to a range of AUD 136 million-AUD 139 million. Full-year guidance implies the second half will contribute around 65% of full-year group EBIT and will be reasonably flat versus the prior comparable period. This reflects a significant improvement on the 21% fall in EBIT versus the prior comparable period in the first half. However, first- half earnings can be volatile due to the seasonal second-half earnings skew, a nuance some investors may not have fully appreciated earlier in the year.

The news that really encouraged the market was G8’s improving occupancy rate trends. For example, in October G8’s occupancy rate appears to have been 80.5% or 0.2% percentage points below the prior year. This represents a big improvement relative to mid-2017 when occupancy rates were falling by 4-5 percentage points per year. G8 estimates a 1-percentage-point change in occupancy equates to around AUD 3.5 million, or a 2%, movement in group EBIT. We are comfortable remaining slightly above the top end of guidance on the basis that the occupancy rate momentum could surprise in the important final two months of the year.

We expect the 48% increase in the G8 share price over the past two weeks was triggered initially by the combination of a relatively high short interest in the stock combined with comments from ASX listed Think Childcare that the childcare sector is starting to see the benefits of the recently introduced Child Care Subsidy, or CCS. G8's improvement in occupancy rate appears to support this view to some degree but the success or failure of childcare centers is also dependent upon the performance and turnover of center employees. G8’s strategy to improve its occupancy rate is very much based on this concept, and the company recently increased early childhood teacher pay by 10% to help reduce turnover. The company is also targeting center quality rating improvements, particularly the 22% of centers with "working toward" ratings, which is likely to boost occupancy rates.