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.

"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.

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