Is $4.00 unreasonable for G8?

Is $4.00 unreasonable for G8?

A few months ago, with their shares trading for $3.80, we asked the question: “Is $5 unreasonable for Ainsworth?” After the subsequent, high quality profit announcement for 2013, and very bright prospects indicated by management for 2014, we believe $5.00 in the next 12-24 months, might not be unreasonable at all.

Today we ask a similar question of G8 Education Limited (GEM). Is $4.00 unreasonable?

A bit of background first. Over the past 18 months, GEM has made the following announcements:

2012
24 Feb – Increased bank facility to $56.5m (replaced NAB with Bank of WA)
24 Feb – bought 1 education centre for $1.6m 4xEBIT
26 Apr – bought 6 education centres for $13m 4xEBIT
11 Sep – bought 3 education centres for $6.2m 4xEBIT
18 Sep – bought 7 education centres for $9.2m 4xEBIT
22 Oct – bought 1 education centre for $9.8m 4xEBIT
12 Nov – bought 14 education centres for $28m 4xEBIT
In total, GEM acquired 32 centres and spent $67.8m

To June 2013 (first 6 months)
6 Feb – raised $35m in equity @1.45 to fund more acquisitions.
19 Feb – bought 12 centres for $18.7m @ 4xEBIT
8 Mar – bought 5 centres for $6.4m @ 4xEBIT
15 Apr – bought 2 centres for $4.8m @ 4xEBIT
30 Apr – bought 3 centres for $3.3m @ 4xEBIT
11 June – bought 17 centres for $24m @ 4xEBIT
To June, GEM has acquired 39 education centres and spent $57.2m.

What we take away from the above is GEM’s clear strategy of rolling-up / acquiring smaller mum and dad-operated childcare centres on an EBIT (Earnings Before Interest and Tax) multiple of just four times.

Management regard this as a continuing opportunity given the fragmented industry left in the wake of the ABC Learning Centres’ collapse and the chance to build an operation with genuine scale efficiencies.

To date, growth has been funded via a combination of internally-generated cash flows, new equity and debt. Looking at the balance sheets for 2011 and 2012, we observe an equity / debt financing mix of ~ 80/20 (as shown) with debt costing 5.5 to 6 per cent per annum.

Reverse engineering the business’s acquisition metrics, we discover that by employing a 4x EBIT multiple, each additional purchase is generating impressive returns on every dollar of incremental equity deployed. Using $10m in purchases as an example:

Purchase price of Childcare Centres: $10m ($8m equity /$2m debt)
Earnings Before Interest & Tax purchased: $2.5m (4x EBIT multiple)
Interest Expenses: $0.12m (20%*$10m*0.06%)
Tax: $.0714m ($2.5m-$0.12m adjusted for 30% tax)
Profit After Tax: $1.67m
Return on Incremental Equity (ROIE): 20.87% ($1.67m / $8m).

An after tax return on incremental equity of 20.87 per cent is impressive, and a characteristic we have seen frequently in rollup type businesses (IIN, TPM, MTU, BGL, CDD, QBE, etc…).

In 2012, GEM deployed an additional ~$67.8m in acquisitions. In the first 6 months of FY13, the company has already deployed $57.2m, and management recently stated that they have a planned ‘floor’ (minimum planned purchases) of $65m and a ‘ceiling’ of ~$100m in incremental capital in any 12 month period. We are quite confident about this projection under current market conditions and at this stage of their business cycle.

Applying the same 4x EBIT metrics to $100m of purchases:

Purchase price of Childcare Centres: $100m
Earnings Before Interest & Tax purchased: $25m
Interest Expenses: $1.2m
Tax: $7.125m
Profit After Tax: $16.67m
Return on Incremental Capital (ROIC): 20.87%

Bear in mind that consensus forecasts currently look like this:

Now consider the facts: In 2011, 2012 and 2013, $148.8m in purchases have been made, equating to an NPAT of $31m at 20.87 per cent after tax return equity vs consensus of $34.2m. And this excludes the business’s profits prior to 2011. If we also focus on the $ value of acquisitions, their trend is accelerating. Hence, we would argue that this number might be conservative.

If $65m is the ‘floor’, we can assume that they will add at least $13.6m in additional NPAT in 2014 and a further $13.6m in 2015. As a base case therefore, we get $58.1m NPAT in 2015.

Considering the bullish case and assuming ~$100m of purchases are made in each of 2014 and 2015, an NPAT forecast of $72.7m emerges, which is well above current market expectations.

Using these numbers rather than consensus, and on current shares outstanding, earnings per share could range between 21-26c per share. With the average industrial company currently trading on ~16x forward earnings, a share price closer to $4.00 is not completely unrealistic.

GEM only has ~3-4 per cent of the market, so they have plenty of room to grow. That’s not the risk. The real risk we see is an irrational competitor coming into the market and destroying the 4x EBIT multiple currently available. This would likely render the business’s economics a less compelling proposition and something any prospective investor must keep an eye out for.

In particular investors in GEM should closely watch developments with Navis Capital, a US based $3b private equity firm, that acquired Guardian Childcare on 8x EBITDA over the weekend – a multiple not seen since the ‘ABC Learning’ days.

The response from GEM has been that they have overpaid in order to get a footing in Australia. Navis paid an equivalent of $4m per centre vs GEM’s $1m average. We would agree that the economics do not stack-up. Hence the current expectation is for the market to remain rational.

There are 6000+ LDCs (Long-Term Day Care Centres) in Australia, with 4000 in GEM’s addressable market, so even if Navis are planning on becoming a second market consolidator, there is plenty of room for both to continue doing well.