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Has GEM learnt lessons from ABC?

Has GEM learnt lessons from ABC?

Childcare operator, G8 Education (ASX: GEM), recently reported its first half 2016 results, and they were not inspiring. EBIT margins are deteriorating under the weight of rising wages and corporate overheads. We don’t yet see it as a repeat of the ABC Learning disaster, but we are keeping our eyes peeled.

Many years ago I warned investors through articles in the press, on TV and radio that a particular company was worth a mere fraction of its then traded price and that it could eventually collapse.  There was a public interest aspect to the proposition because that company was involved in the care and education of our youngest children.

That forecast proved correct when the company, ABC Learning Centres, eventually collapsed having debt-funded the overpayment for centres.

As I examine the latest results of a company that is now performing the same education role, I wonder if a similar share price path may transpire even if, on this occasion, the company does not look to be in terminal trouble.

G8 Education (ASX: GEM) recently reported its first half 2016 results and the reading was not pleasant.  Revenue missed consensus estimates by 4.2 per cent and the earnings before interest and tax (EBIT) margin was 17 per cent against 19 per cent for the previous corresponding period.  More concerning was that for centres acquired before 2015, we estimate the like-for-like incremental EBIT margin was just 2.8 per cent despite the fact that like-for-like revenue growth for these centres was 8 per cent thanks in part to a January fee increase.

For centres acquired before 2014, EBIT grew 17 per cent between the first half of 2014 and the first half of 2015.  But for the same centres, EBIT only grew 0.7 per cent between the first half of 2015 and the first half of 2016.  This represents a very significant deceleration.

In the first half of 2015 the EBIT of $59.4mln, for centres acquired before 2015, equated to an EBIT margin of 20.7 per cent.  In the first half of 2016 EBIT had only grown by 1.1 per cent to $60mln for centres acquired before 2015 and the EBIT margin had declined to 19.3 per cent.  The increase in revenue between these two halves produced an EBIT increase of only $644,000 or an incremental margin of just 2.8 per cent.  Another very significant deceleration.

Part of the reason for the deteriorating margins is a 10 per cent increase in wages thanks to the imposition of higher carer-to-child ratios that came into force on 1 January 2016.  In NSW, QLD and SA, ratios decreased from one teacher for every eight 2-3yr-old eight children to one teacher for every five children.

Another interesting aspect to the result and associated commentary was that management did not update their ‘guidance’ from the full year 2015 results announcement, in February 2016, when they forecast double digit earnings growth.  Given that GAAP earnings declined by 16 per cent in the first half (-3 per cent on and adjusted EPS basis) achieving a double digit full year result means the second half has to grow very strongly.  In fact the implied second half GAAP earnings per share of 18.3 cents suggests 11 per cent YOY growth, which is optimistic given consensus growth estimates are flat for GAAP EBIT.  The market could be very disappointed.

Subtracting the GAAP EBIT of $60mln from Centre EBIT of $68.5mln provides an expected corporate Corporate cost of $8.5mln for the first half.  Performing the same calculation for the 2015 corresponding period we arrive at corporate overheads of just $2.4mln.

Changes of such magnitude are a possible red flag because it suggests the cost allocation method between halves may have been changed, which seems unlikely given it is a fixed cost, or some of the centre operating costs have been allocated to corporate overhead.  If it was the latter it could mean that the centres are even less profitable than the accounts suggest.

Another red flag for us is always the resignation of an auditor.  In November 2015 (effective May 2016) HLB Mann Judd resigned as auditor after six years.

If individual centres are suffering from margin compression or contraction more of the future revenue and earnings growth will depend on acquisitions.  But the rate of acquisitions is slowing.  In 2014 the company acquired more than 200 centres.  In 2015 that number was closer to just 50 and in 2016 only 9 were acquired so far with an expected 12 in the second half.

Finally, in 2014 the company made the statement that the relatively large 2014 acquisition of Sterling was made at 5.8 times anticipated EBIT for the year ending 31 December 2015.  We now have the 2015 EBIT number for the company.  Sterling was acquired for $228 million and management’s anticipated 5.8X multiple implies an EBIT for Sterling of $39.4mln.  The remainder of the year’s EBIT amounts to $33.2mln and the remainder of the funds used to acquire centres was $248.7mln, which implies the remaining centres were acquired for 7.5 times EBIT.

This latter finding is in stark contrast to the case studies included in the company’s own 2015 results presentation for small acquisitions for 2010-2013 on 1-year forward multiples of 2.85X to 4.26X.

So the company is paying more for acquisitions, there are fewer being acquired and those that have been acquired appear to becoming less profitable.  Meanwhile corporate overheads appear to have risen materially.  We’ll leave it for you to watch whether these metrics improve in the coming six months or deteriorate further.

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Roger is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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9 Comments

  1. Andrew Johnson
    :

    Thought I’d revisit this 14 months on with the share price now up 44% since your article and with dividends included a total TSR of 53%. Roger, you raised ‘red flags’ but did you bother to look into any of these any further before you wrote this article? Seems like very superficial and rear window investing.

    And Ben, it’s been 14 months and what impact has private equity had?? G8 did raise equity and yet the stock has still out-performed significantly. Short sellers beware.

    • Thanks for the update Andrew. I wrote “on this occasion, the company does not look to be in terminal trouble.” I also ended the article by saying “We’ll leave it for you to watch whether these metrics improve in the coming six months or deteriorate further.” Did you look into whether the metrics improved? if they have, then you have your explanation.

  2. Andrew Johnson
    :

    It will be interesting to watch the next 6 months of G8. It is obvious to compare it with ABC, and indeed an important analysis to do. There are some critical differences however. G8 have superior cash conversion, board independence (esp Chairman who is on Westfield and HSBC boards), Auditor (E&Y vs Pitcher- note Mann Judd were ditched for E&Y a green flag…), a proven CFO for a start. The other observation is assuming the 7.5x EBIT acquisition multiple is correct, that is still a return on funds >13% ! I’d like to earn that with these interest rates.. Fast Eddy Groves used to pay >12xEBITDA ! and that was capitalising things that should have been OPEX….anyway lets see what happens..ps Bain paid >11x for their acquisition….

  3. The arrival of private equity player Bain in the Australian childcare this week put further pressure on G8. Bain has acquired an operator of high fee “premium” centres and according to yesterdays AFR has plans to roll the model out nationally. This adds to an already well supplied market and targets the high fee premium market that G8 has made such a priority of targeting in the past. G8 has a geared balance sheet and a high degree of operating leverage given the bulk of its running costs are fixed (rent and wages). The groups failure to obtain bank debt may point to deeper issues and we would not be surprised to see them tap the market for further equity. Buyer beware.

  4. Roger, thank you so much. There have been increasing concerns about this company. Forgive me for my possible ignorance, but on my basic reading of this report, underlying EPS was 8.5 cents/share but they have paid 24 cents annual dividend. There was no upcoming quarterly dividend announced. To me, it just don’t add up.

  5. Ah yes. I remember seeing some fellow I didn’t know absolutely caning ABC on Sky Business channel in about 2006 or 2007. ABC was still a market darling at the time but I had some reservations (not that my assessment was very sophisticated). I have learned a bit from this chap since, no prizes for guessing his name.

    I never bought GEM as I had the memory of ABC in mind and watched it rise dramatically for a period of time, with some envy I’ll admit. However it seems to be hard for companies rolling up fragmented industries to maintain their purchasing discipline as vendors get wise, opportunities dry up or competitors encroach. I must say, I don’t really trust acquisitive companies.

    • Hi Greg. It was a great fun explaining the ABC Leaning Centres valuation of 30 cents. When the Singaporean wealth fund, Temasek, was buying in the placement at $7.20 I do suspect that hadn’t seen our work on it.

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