G8 Education's pain is short term, says Morningstar
Poor occupancy rates have hurt the childcare provider but there are reasons to be cheerful, says Gareth James.
Mentioned: G8 Education Ltd (GEM)
Morningstar equity analyst Gareth James is the first to admit the past few years have been a “painful process” for G8 Education, a four-star consumer defensive stock and Australia’s second largest childcare centre provider.
G8 Education (ASX: GEM) has pursued what James describes as an “aggressive and unsustainable” acquisition strategy; and its share price has fallen by 40 per cent in the past three years amid fears of a glut of childcare centres and weak occupancy rates.
G8 fell 17.8 per cent to a one-year low of $2.13 last week after flagging its second profit downgrade in three months, saying that occupancy rates weren't growing as fast as expected, while wages were $3 million above forecast.
James has lowered his earnings forecast in line with that guidance and trimmed his fair value estimate but says there are reasons to be optimistic about a rebound in demand for childcare.
G8 has overhauled its business model to focus less on acquisitions – a strategy that for some investors recalls the collapse of ABC Learning in 2008 – and more on childcare service quality.
James expects a rebound in childcare occupancy rates to 80 per cent within three years, from about 75 per cent currently. And earnings margins are forecast to reach 18 per cent by fiscal 2023, up from 15 per cent in fiscal 2019.
“The past three years have included necessary cultural and strategic changes at the company which has been a painful process,” says James in his latest research note.
“We look beyond G8’s short-term challenges and remember that the childcare sector is highly defensive and demand for childcare services will continue to grow for the foreseeable future.
“G8 Education is the second largest childcare provider in the country and there’s no reason this won’t continue to be the case, rather the company is likely to increase its market share.”
For the record, Australia’s largest childcare provider is Goodstart Early Learning – a not-for-profit organisation that runs 649 centres. G8 Education runs 500 centres in Australia, implying a market share of around 7 per cent, with a further 21 centres in Singapore.
Long-term demographic factors may also help G8’s fortunes. James expects the company to benefit from:
- a growing population of 0- to 5-year-olds
- an increasing proportion of children using childcare
- an increasing female workforce participation rate
- increasing time spent by children in care each day
- increasing childcare fees
Earlier this month, G8 Education entered Morningstar’s Global Equity Best Ideas list and is significantly undervalued, James says.
He has cut his fair value estimate by 12 per cent to $3.08 per share. At 2.30pm on Tuesday, it was priced at $1.96 – a discount of 36 per cent.
It has a compelling dividend yield of 5.2 per cent or 7.4 per cent when you include franking credits.
The key driver of profitability for a childcare centre is its occupancy rate and G8’s 7 per cent profit downgrade earlier this month was caused by a lower than expected improvement this year.
The company cut its underlying earnings before interest and tax (EBIT) guidance from the $140 million to $145 million provided at the half-year result in August to $131 million to $134 million.
“In isolation, the profit guidance looks reasonably small and the 18 per cent fall in the share price excessive,” says James, who says that despite the short-term pain, the company is not facing structural decline its business.
“Although G8’s occupancy rates remain under pressure, we don’t believe they are experiencing a structural decline and we think it’s more likely that the industry will experience periods of both undersupply and oversupply.”
Management also missed their own goal of wages improvement in the third quarter, but James says the fourth quarter is performing in line with expectations.
In addition, management expect to incur $10 million in "one off" costs relating to efforts to "turnaround" underperforming centres in fiscal 2020.
This might upset the market, but it is a sign, James says, that the company is focused on improving its centres to meet standards set by the National Quality Standard – a national quality benchmark for childcare centres.
Banking on boost in occupancy rates
G8 Education’s share price has fallen by 40 per cent over the past three years but James says it’s worth remembering that the company is profitable and pays fully franked dividends.
“Over the past three years 65 cents per share has been paid in dividends and franking credits which reduces the decline to 20 per cent on a total return basis. G8 earnings and share price are also highly sensitive to occupancy rates but this can be a benefit as well as a drawback.
“For example, in late 2018, the share price jumped 80 per cent in just four months as the occupancy rate outlook improved. We expect occupancy rate improvement to be the main catalyst which will restore confidence in the stock and close the price to fair value discount.”
5pc growth over the next decade
James’s revised fair value estimate of $3.08 per share implies fiscal 2019 price/earnings of 22 times, enterprise value/EBITDA of 6.5 times, and a free cash flow yield of 3.7 per cent.
Over the next decade, he forecasts an earnings per share growth of 5 per cent; however, this largely depends on the rate of acquisitions and the ability to fund them in the capital markets.
“We estimate a further $60 million in fiscal 2019 at 4.0 times EBIT. We view this as reasonable, considering that the company has spent more than $800 million on acquisitions during the past five years.”