Reporting Season Avalanche
After a little digging, we were impressed by the results of both Challenger Limited (CGF) and G8 Education Limited (GEM). Below follow a few points on each business (both of which are in the top ten holdings of either or both The Montgomery Fund and The Montgomery [Private] Fund).
Challenger (ASX:CGF)
Perhaps the biggest news is that the lifetime annuity business – an area we believe legislation may provide additional support to for demographic and financial reasons – produced sales in the first half of FY14 that exceeded the total sales for FY13.
Headlines
- Funds Under Management up 27% to $45b. CGF moves from 9th to 7th Australian fund manager
- Normalised NPAT up 10% to $164m – slightly ahead of consensus
- Normalised ROE 16.2%
Capital position
- Around 1.4x required capital on a post-regulatory increase basis
- Intending to pay out a 40-45% dividend
Annuity business
- Record annuity sales of $1.75b, of which $1.46b is retail
- Division EBIT up 67% to $201m
- Retail sales up 38%. Baby boomers showing a taste for annuity products as they retire
- Average term of new business 6.4 years, up from 6.2 years PCP
- Total life business book at $10.9b at period end. Up 7% on the previous December
- Average margin on the book steady at 4.4%
Funds Management
- Net inflows of $1.1b
- Good outperformance in Fidante Partners (boutique)
- Division FUM up 27% to $45b
- Division EBIT up 60% to $21m – still only 10% of total EBIT, but growing well
- Division ROE at around 22% (needs to be normalised for performance fees)
- Challenger Investment Partners business continues slow decline. This business serves primarily internal clients and has some products in runoff, although third party clients are increasing
Outlook
- CGF increasing growth target for life business on the back of good annuity sales
- Now targeting 10-12% growth with stable margins
- Funds management obviously more difficult to predict
Analyst comment
All parts of CGF’s business appear to be performing well. The annuity business in particular, which represents the bulk of earnings, is growing at a good rate. This reflects the demographic shift of baby boomers entering retirement, as well as an apparent increasing interest in annuity products from baby boomers.
CGF remains a somewhat complex business, with statutory earnings reflecting a combination of operating performance, investment performance, and changes to actuarial assumptions.
Note that after-tax earnings are forecast to decline in FY15, as a result of tax losses being consumed.
G8 Education: (ASX:GEM)
GEM has a December year-end, and has just reported its FY13 results. Following our meeting with the company, the business’ results continue to appear to be tracking in line with our estimates at the time of purchase, which we must note have been more optimistic than those of other analysts.
Our main assumption is for dramatic growth to circa $70 million NPAT in 2015, which compares to contemporaneous consensus analyst estimates of $41.6 million.
Consensus earnings estimates have since grown 16 per cent to $48.2 million, but appear to exclude any additional centre acquisitions, which are being purchased at four times EBIT.
By way of example, on February 7, GEM acquired 63 centres and an additional $26.06 million EBIT for $104.67 million. One would expect analysts to upgrade 2014 estimates and beyond.
Despite growth being of the ‘acquired’ variety, ROIC continues to improve the longer centres are under GEM control. ROIC has improved from 23.8 per cent to 25.9 per cent currently. This reflects a number of integration benefits, including a reduction in the all-important ‘head office cost per licenced place’. The biggest incremental improvements come from a rise in occupancy, demonstrated as per the following graph:
- Across 126 centres, average occupancy over 2013 improved from 82% to 83.8%
- Given the business’ large fixed cost base in staff, any revenue improvement flowing from improved staff vs. student ratios flows largely to the bottom line
- Systems are being rolled out to more efficiently reallocate daily places vacated by illness or holiday, reflecting management’s commitment to profitable enhancement
- Market opportunity remains large. GEM has 297 centres and there exists an identified universe of approximately 4000 centres with 1500 possible vendors. At any time however, only 5% of those may be interested in selling
- Cash flow currently at ~$35m. With a 30% debt funded mix, and solid continued growth, the business could generate annual cash flow to fund ~$45m-$60m in acquisitions
Roger Montgomery 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.
Carlos
:
Lloyd and Paul. ABC went broke as they were hugely in debt by paying excessive amounts ( up to 12 x EBIT ) for child centres. GEM on the other hand is only paying 4x for child centres and is on a gearing ratio of 12%.
How is that “loading up on debt” ? Totally different companies.
bruce marks
:
Hi Roger
I read with interest when you wrote about GEM some months ago, posing the question “is $4 unreasonable”?
The calculations made will no doubt be useful in your next edition of Value.able.
Happily, it was well worth my while re-reading the article as the share price sagged following the listing of Affinity, and now we have been well rewarded with great results and a perky share price.
So what do you see as “not unreasonable” for calendar year 2015?
Roger Montgomery
:
We’re always happy to write about and share what we are actually discussing here at the office. We don’t ever expect everyone to agree but we do hope to always add some value.
Paul Middleton
:
Tend to agree with you Lloyd.
I prefer to invest in those companies who, when using the acquisition route for growth, do it in a measured and methodical way. It may not be as exciting, but for me, it appears a sustainable and low-risk strategy without piling up the debt. (eg AKG).
Robert Stevenson
:
Love your insights, Roger. You have earnt my trust all the years I’ve been following your blog. If I had enough discretionary cash to invest in your fund, I would be rest assured it’s in safe hands. Keep up the great work!
Roger Montgomery
:
Thanks Robert, we look forward to working for you one day!
Tony C
:
When you see the CEO of GEM jetting of on private planes ABC style its time to worry
Bill Reid
:
Hi Roger and Co.,
I note that you refer to NROE in the attached article. In your book “Valuable” you use ROE for determining IV. Have you now switched to using NROE to determine IV?
Roger Montgomery
:
No change. Interchangeable
Adam Novek
:
Hi Roger,
To be honest I always get a bit hesitant when it comes to investing in childcare. It is just not an exciting thing to invest in but still AFJ seems to me like it could pose some competition to G8. Both have similar growth strategies. Have you looked into how you think AFJ will affect G8?
Thank you
Roger Montgomery
:
Affinity appear to be a long way behind in terms of integration. They’re unlikely to make acquisitions while bogged down getting the base assets humming.
chris britton
:
Hello Roger
I had a question on normalising NPAT, particularly where company is not paying standard company tax rates – such as in the case where they have carry forward losses – this obviously means the NPAT figure will be higher than if they didn’t. When determining ROE/EPS/NPAT inputs, is it prudent to adopt the standard tax rate, as otherwise it appears as though results may be a little inflated to determine what the true performance would be?
Roger Montgomery
:
The tax benefits you receive while carrying forward the losses are real at the time and should not be ignored. In the future however the ROE may change and so a weighting/probability approach can be adopted to arrive at the estimate. Hope that helps.
lloyd taylor
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I look at GEM and it looks like the start of a re-run of the movie called ABC!
Roger Montgomery
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That’s nonsense and simplistic. It will only roll out that way if they start and then persist in paying too much for centers.
lloyd taylor
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“It will only roll out that way if they start and then persist in paying too much for centers” to which I would add with a debt funded business model.
Yet isn’t that the fatal flaw with all acquisition based growth strategies? Serial acquirers eventually do exactly as your caveat states. Without serial acquisitions there is no material growth, which is what the market demands. Yet with serial acquisitions the price of inevitably rises and the debt on the balance sheet balloons. The market cheers and the treadmill continues to grind ever upwards.
With a five year funding gap of $232 million partially funded by $105 million of increased debt, it is hard to say that GEM’s growth model is materially different to that seen before in the childcare industry. As I said, it sure looks like the start of a re-run of that movie. If they stop acquiring then the growth premium placed on the business by the market evaporates, which is not a strong incentive to stop.
So I suggests that its “nonsense and simplistic” only if you believe that human nature will be denied in GEM’s business model.
It never pays to underestimate human nature in business, or any other activity for that matter. But I am sure you are smart enough to head for the exit before the inevitable! But doesn’t every fund manager think that?
Roger Montgomery
:
replace broad generalistions with facts.