Bumper Supply Constraining Childcare Profits

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

Benefits of government subsidy increases are likely to be constrained in the near term for childcare centres, as supply is overwhelming demand.

-Earnings momentum in childcare centres expected to return as more families use additional government funding
-Supply to date in 2018 indicates a new peak in the opening of centres is forming
-Think Childcare proactively taking steps to ensure new subsidy benefits are reflected in its occupancy rate
 

By Eva Brocklehurst

An increase in government funding for childcare has generated a mixed view about the benefits to parents and flow on to occupancy, and the industry is not overly optimistic about improving profitability.

Moreover, Canaccord Genuity assesses that any benefit is likely to be constrained in the near term because of a continued increase in the supply of centres, with a 2.5% increase for the five months to May 31, 2018. This is expected to weigh on earnings in 2018.

In the longer term, the broker is more positive and expects earnings momentum to return as demand plays catch up and more families utilise additional government funding.

In the broker's recent survey of child care centres just 24% of respondents believed changes to the government subsidy would positively affect profitability. General awareness of the changes should be high, as a majority of centres have indicated they have been actively discussing this with parents.Of the centres surveyed, 28% indicated they would raise fees as a result of the new subsidy. This does not mean that the other 72% will not increase rates, as Canaccord Genuity suspects some will do so regardless of a change in subsidy.

Reasons for subdued profitability are based on concerns about occupancy rates. In the five months to May 31, 2018 there were 182 new childcare centres opened in Australia versus 152 during the same period in 2017.

A general view is that supply growth peaked in early 2017, although supply to date in 2018 indicates a new peak may be forming which points to 370-380 new centres being opened this year.

New funding from the government from July 2 is expected to drive demand but this should take time to be realised, as parents respond to the new structure and likely benefits in 2019.

Consequently, while maintaining a positive view on the sector, Canaccord Genuity expects conditions will remain challenging in the near term.

G8 Education

The new supply has continued to affect G8 Education ((GEM)), which flagged in April that year-to-date occupancy was down -2.5-3.0%.

As a result, and together with the latest supply data, Canaccord Genuity, not one of the eight brokers monitored daily on the FNArena database, downgrades its rating to Hold on the stock. Target is reduced to $2.60 from $3.60.

Location analysis shows that 42 of the 182 new childcare centres opened are located within an 2km radius of a G8 Education centre. In the past 18 months around 100 centres have opened within such a radius. This could affect the occupancy rates of around 20% of the company's portfolio.

There are a number of other considerations, including speculation regarding a purchase of Affinity Education ((AFJ)). Canaccord Genuity considers this highly unlikely as while the portfolio is similarly well positioned to benefit from funding changes, the multiples being speculated would mean any transaction would not be accretive.

Depending on the level of acquisition expenditure in 2018, the broker estimates G8 Education's net debt will peak at around $350-400m, which places it outside of the desired target.

In addition the company has a current Singapore bond worth SGD270m maturing in May 2019. Refinancing should be simple but is also likely to weigh on investor views in the interim. As a result, the broker forecasts that G8 Education will spend less on acquisitions in 2018.

The company could become a takeover target because of the strong presence of private equity in the sector, Canaccord Genuity suggests. Childcare generates cash flow which can be leveraged and current trading multiples remain attractive.

The FNArena database has three Buy ratings and three Hold for G8 Education. The consensus target is $3.03, suggesting 31.1% upside to the last share price. The dividend yield on FY18 and FY19 forecasts is 8.5% and 8.4% respectively.

Think Childcare

Of the new centres opened only two are within a 2-3km radius of a Think Childcare ((TNK)) centre and, therefore, the broker suggests this company will be less affected. There have been 10 new centres opened over the past 18 months within a 2km radius of a Think Childcare centre, or 21% of the portfolio.

The broker believes the size and mix of the portfolio should enable Think Childcare to better withstand competition. The company has analysed its customer base and noted that 99.4% of families that currently receive the childcare benefit will be better off under the new subsidy.

Think Childcare has been proactively attempting to ensure gains are reflected in its occupancy rates. Canaccord Genuity notes the company has a strengthened balance sheet and a substantial pipeline of acquisitions. The stock remains attractively priced and the broker rates Think Childcare a Buy with a target of $2.58.

Canaccord Genuity's survey covering private owners and operators of child care centres was conducted just prior to the government's accelerated promotion of its new subsidy. Responses were received from 637 out of 5237 surveys that were sent out.

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