Description

G8 Education Ltd operates over 500 child care centers and is the leading for profit early education provider in Australia. The stock has been negatively impacted with record levels of supply reducing occupancy levels in 2017. As a result, the company withdrew its 2019 EPS guidance of $0.40 per share.

In one month, Australia will introduce a new Child Care Subsidy program that will vastly improve the affordability of child care while also providing direct payments to the suppliers.

Against the backdrop of affordability issues for families and the ratcheting up of competing child care centers, G8 has nonetheless produced EBIT of A$160M, A$161M and A$151M for the last three calendar years, which represents a current multiple of 9.2x EV/EBIT on its A$1.38B enterprise value.

While growth expectations for this previously high-flying (or at least, getting-ahead-of-itself) stock have been impaired, reasonable investors would have argued that a roll-up private-to-public arbitrage story should never have gotten this far ahead of itself. Especially one that should be logically constrained by needing to fund its growth via equity issuance for what has been a 7% ROA / 13% ROE business. Management must have agreed, as they had been serial issues of stock throughout the higher valuations:

Currently, the shares are trading for A$2.49/share.

The alert for this investment came via a brief comment in the 2017 Q4 commentary by the FPA International Value Fund, which sums up the situation concisely:

“Based in Australia, G8 is one of the country’s largest operators of childcare centers. The company is one of the most recent additions to our portfolio. In recent months, G8 has experienced weaker performance following the complete overhaul of its management team and significant subsequent transformation initiatives, along with deteriorating occupancy levels in the face of excess supply coming into the market. In the short term, we expect the business to remain under pressure as it works through some of these challenges, and as a new government scheme for all-day childcare subsidies comes into effect in 2018.”

Despite the recently more challenging environment, G8 has been able to produce consistent EBIT, which in turn should be boosted by the steady pace of recent development via recent greenfield centers which tend to contribute meaningful EBIT with a lag.

The new program in Australia for childcare will combine what had previously been two programs into one. Beginning July 2, 2018, the new “Jobs for Families” Child Care package is expected to increase government funding by approximately 20%. The new child care funding packing is a benefit to 95% of existing G8 families, and the company expects a resulting positive impact on occupancy and revenues in H2 (company trading update and outlook from May 3, 2018).

The new Child Care Subsidy will replace the two current child care payments—the Child Care Benefit and the Child Care Rebate. The new program will pay directly to services. There are also changes to the annual cap which will make child care more affordable for most families.

Much of the recent supply might be attributable to the anticipation of this increased funding. Australia has long been mindful of adopting family friendly policies to fight weakening demographics. Areas in which programs have lagged these goals are inevitably due for review and improvement.

Regarding the supply of new centers, Industry commentary does suggest that while this might take a few years to work out, additional interim supply is starting to be constrained by more restrictive lending conditions. Of course, anticipation of lending restraint in the Australian market should always be taken with a grain of salt.

More to the point, G8 is not the only company that has cited the attractiveness of the new Child Care Subsidy scheme. Yesterday, Think Childcare Ltd, which operates 37 childcare facilities in Australia, announced that 99.4% of their families receiving CCB will save under CCS: https://www.asx.com.au/asxpdf/20180531/pdf/43vfv9cwcz8h7z.pdf

Here is some additional color from the press release:

“Overnight, on the 30th of June 2018 we are going from childcare being the most expensive for some considerable time to childcare being the cheapest it has ever been in Australia.”

…

“We have commenced letterbox dropping 5,836,000 DL flyers, reaching 729,000 households around THINK’s and our managed centres…”

The industry remains highly fragmented, with the top five players accounting for 24% of the market. G8 operates close to two-dozen brands, but it is expected that these will be steadily consolidated.

In 2015, G8 was involved in a contest to buyout Affinity Education Group Ltd, which eventually sold to private equity in December 2015 for over $200M as Affinity was embarking on a feverish growth phase. By complete coincidence of timing vis-à-vis this write-up, the Australian Financial Review just announced yesterday that the company is being shopped at multiples considerably above G8’s current valuation: https://www.afr.com/street-talk/sale-docs-out-for-anchorages-700m-child-care-company-20180530-h10r4y

Sale docs out for Anchorage's $700m child care company

Sydney-based private equity firm Anchorage Capital Partners is ramping up plans to sell childcare business Affinity Education. 

As first reported by Street Talk, Anchorage and adviser Luminis Partners sent an information memorandum to buyers this week. 

The IM pegs Affinity's earnings before interest, tax, depreciation and amortisation in the "mid $60 millions", sources said, driving expectations of about a $700 million-odd deal. 

It is understood the document seeks to explain how Affinity Education has changed under Anchorage's ownership, and since its last publicly available accounts were released in 2015. 

It said Affinity had a portfolio of 166 childcare centres which had been materially retooled "into clusters", based on geography, to ensure efficiency and scale in the right areas. 

It's understood the business is pitched at big private equity firms, including those that missed out on buying Camp Australia such as KKR & Co, Bain Capital and Barings Private Equity. Industry player G8 Education is also on record saying it will take a look. 

Sources said the IM also addressed changes to childcare funding, which are due nationally from July 1, and its likely impact on the business. 

The government is replacing its child care benefit and rebate scheme with a child care subsidy, which will impact the rebate received for some child care users. 

Indicative bids are due in mid-July, sources said. 

By comparison to that guidance towards an 11x EBITDA deal multiple, G8 has had consistent EBITDA of approximately $127M over the last three years for a current trailing multiple of 8.4x EV/EBITDA and a 2019 estimated forward multiple of 6.8x.

New management has been successful in improving the quality of G8’s centers, through a combination of stemming turnover for their key Centre Manager cohort and via the increase of centers receiving high quality audit marks.

While the company has pulled the plug on previous guidance of A$0.40/share for 2019, which would represent a P/E of est. 6.2x, it doesn’t seem unreasonable that once the industry works through some of the recent supply imbalance and begins to benefit from the dramatically more attractive childcare subsidies, that this reasoning laid out in their 2/25/2018 earnings call could put the company on track for hitting those levels in 2020:

The 2019 strategic goals have remained unchanged [note: that was February, they pulled the $0.40 guidance in May]. Certainly, in discussions with a number of you over the course late last year there was a rightful challenge on whether we will hit our AUD 0.40 EPS target. And I flagged, 2017 certainly has not helped. However, we remain committed to that target. And I think there'll be a number of milestones over the next 12 months which will indicate whether we will achieve that in time, a couple of those being, firstly a stabilization and slight turning in the right direction of occupancy in the first half of the year which we'll know by August. The impact of the Jobs for Families Package which comes into effect in the second half of this year, we will start to have an early read on that in the early part of 2019. And in the second half of 2018, we'll have a good handle on our ability to rollout new revenue streams.

So, in August this year, we'll have a much better handle on whether the occupancy that's required to hit that target will be achievable, whether the new revenue streams will be achievable. If they are both heading in the right direction, then our comfort level around hitting that is certainly enhanced. And clearly, the ongoing performance of our development portfolio is a key to hitting that number. So we'll wait and see, but we're not giving up on that target as yet [note: ibid].

In terms of the elements of the strategy, they remain largely unchanged as you'd expect. We're very confident we've got the right strategic plan; it's now a matter of executing. What you'll see more of in 2018 is more investment in quality of our assets.

This was the first earnings call representing the strategic direction of the new executive team, which they had only finished assembling in mid-January.

G8 will have over 550 centers once the current pipeline of 40 additional centers is complete. In 2018, they are developing 30 centers at a cost of A$120M. These new centers, of course, won’t be a material contributor of EBIT for the year, primarily due to start-up costs. Thus, the income statement should be improving with a lag. Also, at an implied build-out of $4M per center for the current cohort, an EV of A$1.38B for 550 centers seems that a center-by-center analysis might imply that G8 is trading reasonably below replacement cost.

Without digging into the weeds, G8 has some interesting cohorts—the company’s revenues at the center level were able to remain flat due to price increases being offset by higher vacancies. High quality centers appear to have significantly better unit economics. Keeping in mind their competitor’s commentary that in less than five weeks, childcare subsidies will go from the most expensive ever to the most attractive ever, it makes sense to pay attention to G8 given its position as the largest for profit in the industry and what appears to be some degree of valuation safety regarding the EBIT consistency of the last three years.

DISCLAIMER:

The author of this posting and related persons or entities (“Author”) may currently holds a position in this security and may hold long or offsetting short positions in related or mentioned securities.  Author may transact in additional shares at any time.  Author has no obligation to inform anyone of any changes to Author’s views.  Please consult your financial, legal, and/or tax advisors before making any investment decisions.  While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note.  The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in mentioned securities.  READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE.  As with all investments, caveat emptor.

Catalyst

The introduction of the new Child Care Subsidy government program at the beginning of July.