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How to play Aussie childcare bonanza

Glenn Freeman  |  01 Feb 2018Text size  Decrease  Increase  |  
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From 2 July 2018, the Federal Government's new funding system will increase subsidies for most families, and government forecasts project a 16 per cent increase in subsidies in fiscal 2019 alone. It tips annual funding to increase by around 40 per cent over the next three years.

"As around 60 per cent of child care fees are funded by government subsidies, we expect this to materially benefit [early childhood education and care] ECEC providers," says Gareth James, Morningstar equity analyst, in a special report released this week. Prem Icon The full report is available to Morningstar Premium subscribers.

James believes government forecasts are overly conservative, given the effect that rising subsidies in the order of 15 per cent have had on operators in the sector between fiscal 2011 and 2016.

While ASX-listed childcare operators such as G8 Education (ASX: GEM) represent obvious targets for investors, "we are reluctant to adopt a more bullish stance until the childcare subsidy begins in fiscal 2019 and we have more information about its impact", James says.

Listed property is a preferred method of gaining exposure to the sector, in the form of real estate investment trusts (REITs).

Non-moat-rated company G8 is the only ECEC operator covered by Morningstar, along with two no-moat-rated REITs: Folkestone Education Trust (ASX: FET) and Arena (ASX: ARF).

"We believe Arena's internalised management structure gives it the edge over Folkestone, should both REITs trade at a similar discount to fair value. Our expectation of earnings growth and childcare operators' credit quality underpins our positive view on child care REITs.

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"Aside from the current share price discount to fair value, we also believe child care REITs are more appealing than child care operators," James says.

There several reasons for this preference for REITs within this theme, including:

  • Better insulation from oversupply
  • Long-weighted average lease expiries
  • Goodwill residing in property
  • REITs can grow via developments
  • Subsidies paid directly to child care centres.

Conversely, James believes low barriers to entry within the ECEC sector leave child care centre operators vulnerable to weaker occupancy rates, weak hourly fee growth and profit margin compression.

As an example of lower volatility among REITs, he refers to Folkstone Education, which was "significantly affected by the ABC Learning collapse, by virtue of its large exposure to ABC Learning properties".

"But its securities were less volatile than ABC, and the REIT survived the turmoil. Similarly, in recent years G8 Education's share price has tended to be more volatile than those of the child care REITs," James says.

ARENA REIT

Morningstar's fair value estimate (FVE) for Arena is $2.50 per security. "Our valuation is derived using a discounted cash flow model with a weighted average cost of capital of 7.3 per cent. Rents are contracted to grow annually at the greater of CPI or 2.5 per cent, with market rent reviews every decade," James says.

He forecasts a 4.1 per cent compound annual growth rate in rental income over the next decade, and like-for-like rental growth of 3.1 per cent over the same period.

Folkestone Education Trust

Folkestone Education Trust has a FVE of $3.20 per unit. "Our valuation is derived using a discounted cash flow model, with a 7.3% weighted average cost of capital," says James.

He says rents are contracted to grow by the greater of CPI or 2.5 per cent annually, with a market rent review at the end of year 10. "Lease expiries are negligible until fiscal 2021, but most of the portfolio is set to expire during fiscal 2021 and 2027."

G8 Education

With a FVE of $4 a share, Morningstar's weighted average cost of capital assumption is based on a 9 per cent cost of equity, "reflecting average levels of business cyclicality".

"For the five years to fiscal 2021, we forecast 6.2 per cent earnings per share growth; however, this largely depends on the rate of acquisitions and the ability to fund these in the capital markets.

"G8's operational expertise has led to margin expansion in recent years, which in turn has significantly improved profitability ... but we forecast a decline to 18 per cent [in earnings before interest and tax margins] by fiscal 2026 due to increasing supply and strong competition," James says.

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Glenn Freeman is a senior editor at Morningstar.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is senior editor for Morningstar Australia

© 2021 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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