G8 Education Could Perform Better By 2019

G8 Education ((GEM)) is withstanding headwinds in its business, amid increased supply of childcare places. The company has renewed its management, board and operating perspective and, having raised new equity, is now focused on growing occupancy.

Channel checks suggest the supply of childcare places could increase 10% over the next 2-3 years, versus demand growth of just 2-3% and Morgan Stanley does not consider this an attractive equation for an industry that has already experienced a slippage in demand.

The company’s growth rate, including M&A and greenfield expansion, is envisaged at around 7-8%. While the broker expects supply will adjust over time, and more sophisticated operators are already shifting their capital elsewhere, this is still an issue for the near term.

The broker is also unimpressed with the growth in wages versus daily rates, which is likely to affect margins. Striking child care workers and oversupply is not a great backdrop for operators. Morgan Stanley does not envisage much scope for positive surprises on this front and considers additional pressure a possibility. Beyond 2018, the broker factors in wage inflation of 8-9% and price increases of 7.5%.

RBC Capital markets initiates on the stock with a Sector Perform and $3 target. The broker, not one of the eight stockbrokers monitored daily on the FNArena database, forecasts a weak first half result and awaits a more attractive entry point once market expectations are re-based. However, this may not be far away, the broker suggests, as the stock is trading at a -15% discount to historical multiples.

Morgans is positive about the outlook, although acknowledges the recent industry challenges. Taking a medium-term view the broker believes the company remains well-positioned to grow via acquisitions as well as organically.

Moreover, improved operating efficiencies and a more stable regulatory and supply backdrop should be supportive. Last month, Morgans initiated coverage on the stock with a Add rating and $3.53 target.

Regulatory Support

A more favourable child care funding regime will also be in place from July this year and this should benefit low and middle income families. The main changes to childcare subsidies include means testing based on combined family income and parental activity testing.

This low-middle income segment represents the bulk of G8 Education’s source but RBC Capital Markets believes the positive financial impact won’t begin cycling through the network until 2019. The broker expects double-digit earnings growth in 2019 and 2020 with a mid single-digit fully franked dividend yield.

Morgan Stanley agrees regulatory change may be a catalyst but unlikely to be realised until next year.

Occupancy

Historically, the first half average occupancy is around 77% and the second half around 83%. January is the lowest occupancy month, as parents typically remove children from day care during school holidays and re-enroll in February.

RBC Capital Markets forecasts average occupancy levels of 75% in 2018, gradually improving to 80% by 2023. There are around 30 new greenfield developments coming on line, which will be a minor drag. The company achieved around 81% average occupancy between 2012-2017.

Supply growth is expected to moderate over the medium term, as more onerous credit restrictions for new childcare developers come on board and the supply responds to falling industry-wide occupancy levels.

Morgan Stanley recently downgraded to Equal-weight from Overweight, primarily because of lower occupancy, which pushed its estimates below consensus for 2018. The broker expects lower occupancy will be compounded by supply and unfavourable daily rates versus wages, calculating occupancy in 2018 at around 77.7% and in 2019 at 79.0%.

The broker observes the market is highly fragmented, with a long tail of independent for-profit providers that have a higher cost base versus G8 Education. These operators need to remain viable for the sustainability of the industry. The company’s scale advantage and ability to consolidate should provide the means for sustaining earnings growth over the longer term.

G8 Education will hold its AGM later this week. FNArena’s database shows three Buy ratings and three Hold. The consensus target is $3.45, suggesting 32.1% upside to the last share price. The dividend yield on FY18 and FY19 forecasts is 7.7% and 8.4% respectively.

See also, Growing Opportunity For G8 Education on March 14, 2018.