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Morningstar | G8 Education’s Outlook Improving as Child Care Centre Oversupply Subsides

The key takeaway from G8 Education’s 2018 financial result was that its occupancy rate is continuing to improve as the industrywide oversupply of child care centres abates. However, improvement is tracking in line with our expectations and the 2018 EBIT of AUD 136 million was broadly in line with our forecast. We were surprised the share price fell by 11%, considering the result provided further evidence of an improving outlook. We expect share price weakness was caused by the relatively weak performance of centres acquired during the past three years, which missed earnings guidance provided last November. However, these centres only comprise about 10% of group EBIT and we don’t consider this a material issue relative to the improving occupancy outlook. It’s also possible share price weakness reflected profit-taking to some degree following the 90% rally over the past four months.

G8 Education’s occupancy comments echoed those from other listed child care centre operators and landlords this reporting season. Namely, that new child care centre construction is being curtailed by a reluctance of financiers to fund development and of operators to sign leases. On the demand side, the introduction of the child care subsidy, or CCS, last July also appears to have boosted demand via increased subsidies, as we envisaged in our February 2018 report: ”How to Play the Child Care Bonanza.” We expect this trend to continue during 2019.

We have largely maintained our earnings forecasts and our AUD 3.50 fair value estimate. Following the share price fall to AUD 3.23, G8 Education is undervalued. The share price implies a 2019 P/E ratio of 15 and a dividend yield of 4.8%, or 6.8% including franking. At our fair value, the P/E ratio is 17 and the dividend yield 4.3%, or 6.1% with franking. We consider the dividend to be sustainable following management’s decision to reduce the payout ratio to 70% to 80% of NPAT.

Although G8’s occupancy rate fell to 74.0% in 2018 from 75.9% in the prior year, the rate of decline has gradually improved over the past couple of years. In mid-2017, for example, G8’s occupancy rate was falling a rate of five percentage points per year, but the rate of decline has gradually reduced and even turned positive in December 2018. Management also claim 2019 occupancy rates are two percentage points above those achieved a year ago, which is tracking in line with our full-year 2019 occupancy forecast 76%.

From a balance sheet perspective, G8 is in reasonable shape, although a sustained deterioration in occupancy rates would create issues for the company. As at Dec. 31, 2018, gearing (net debt/net debt plus equity) was 26%, but increases to 55% if adjusted for capitalised operating leases. Similarly, EBIT/net interest expense of 4.8 shouldn’t be an issue, although EBITDAR/fixed charge cover is tighter at 1.9. Management expects net debt/EBITDA to peak at 2.4 in the second quarter of 2019 due to the cost of new centre openings, the low profitability of centres in ramp-up, and the second-half seasonal earnings skew of the company. However, we expect gearing to improve from the second half of 2019 and to steadily decline towards management’s long-term target range of 1.5 to 1.7 over the next 18 months.

Importantly, the company refinanced debts on more favourable terms in 2018, resulting in longer maturities and lower interest costs. At peak leverage in the first-half of 2019, the company should still have headroom of about AUD 100 million in undrawn debt and cash. G8 Education also has good cash conversion which we expect to continue.

From an operational perspective, G8 is performing well and we continue to be impressed by the management team and the cultural changes underway at the company. The executive team continues to strengthen, with the recent appointment of a Head of Learning and Education, a key hire in such a regulated sector. However. head office costs are likely to plateau now that the executive team is largely in place. The national call centre also recently launched and is already servicing 100 child care centres with a further 400 centres to be connected in early April 2019.