Can G8 Education’s Acquisition Rate Continue?

This story features G8 EDUCATION LIMITED. For more info SHARE ANALYSIS: GEM

-Queries over funding options
-fundamentals remain positive
-Uncertainty in government policy
 

By Eva Brocklehurst

G8 Education ((GEM)) has been accumulating child care centres at a racing pace but broker enthusiasm has waned somewhat. The highlight of the 2014 results was a strong increase in dividends. Dividends will be fully underwritten over the short term to retain balance sheet capacity and flexibility.

The main issue as far as UBS is concerned is the company’s ability to source funds for future acquisitions. G8 Education has announced another $29.9m in acquisitions and the broker estimates there is $26m in cash at hand, ahead of free cash flow and dividend investment plan (DRP) underwriting. Based on the broker’s analysis, the company can fund the acquisition of 75 centres annually, via a mixture of cash, free cash flow and the underwritten DRP. UBS retains a Buy rating and believes the market, having sold off the stock after the results, is taking a short-term negative view about the company’s ability to consolidate the child care industry at the same rate it has managed over recent years.

Citi is concerned about the pace of acquisitions, finding it hard to assess the trend in underlying earnings. Organic growth figures exhibit solid top line growth and operating leverage, but these older centres now represent just a third of the current run rate. The company has signalled strong fee increases across the portfolio and, in the short term, revenue may rise ahead of costs, but Citi expects a clawing back in income as new child-to-staff ratios commence in 2016. How easily the industry can pass through additional costs will depend on government funding policy. The broker is not convinced that the consolidation strategy provides investors with enough value and retains a Sell rating.

Another risk the broker highlights is the Singaporean debt totalling SGD260m. The headline interest cost at 4.75% may look attractive but this debt has not been swapped back into Australian dollars and the company has taken on the currency risk. Citi warns that, by not hedging, interest costs are more attractive but a depreciating AUD/SGD will likely destroy shareholder value.

Macquarie observes that obtaining debt for child care assets in Australia has always been a challenge. Banks require a right of entry clause on the lease in order to lend to operators. As G8 Education acquires the operations as opposed to the property many centres have legacy lease terms, so this clause is regularly omitted. Hence, this has led the company to source unsecured corporate notes as opposed to standard secured borrowing. Macquarie considers the debt position is manageable, but further funding will be required to maintain the growth trajectory into 2016. Any further material acquisitions in 2015 are likely to require another round of equity funding, in the broker’s view.

Positives exist in macro terms around child care and the consolidation opportunity, in Macquarie’s view. Margins are strong too, as the company leverages the scale benefits of a larger network. Nevertheless, the broker does caution about increased competition, uncertainty over the federal government’s response to the Productivity Commission report on child care and narrowing capital management options, which could put downward pressure on the stock in the near term. While still expecting earnings to grow at double digit rates in 2015, Macquarie downgrades to Neutral from Outperform.

Deutsche Bank considers the growth outlook has been strengthened by the addition of the 12 new centres and envisages upside earnings risk in 2015. The broker notes the company did not provide 2015 earnings guidance but did signal that the opportunity for disciplined acquisitions remained significant and the company is well positioned. Morgans finds the operating metrics hard to fault and assumes acquisitions of 50 centres per annum, conceding a more accelerated rate would require funding options to be considered. The broker was also concerned abut the FX translation loss in  2014, estimating that if the current spot rate holds, a further post-tax FX translation loss of $4.0m will be required.

FNArena’s database has three Buy ratings, one Hold and one Sell for G8 Education. The consensus target is $5.30, suggesting 28.6% upside to the last share price. This compares with $5.83 ahead of the results. Targets range from $4.00 (Citi) to $6.22 (UBS). The dividend yield on FY15 and FY16 forecasts is 6.3% and 7.0% respectively.
 

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