Australia | Dec 05 2017
This story features G8 EDUCATION LIMITED. For more info SHARE ANALYSIS: GEM
A slump in occupancy and higher costs have driven G8 Education to downgrade earnings. Many brokers consider the drop in the share price presents an opportunity.
-Several contributing factors to the downgrade temporary in nature
-Supply-driven risks likely to continue into the first half of 2018
-High sensitivity to changes in occupancy rates
By Eva Brocklehurst
A surprise downgrade by G8 Education ((GEM)) led to a sharp sell-off in share price yesterday but most brokers believe this was undeserved, and it is an opportune time to buy. The main reasons cited for the reduction in 2017 estimates included new childcare supply, higher costs relating to staff changes and an increase in training costs. The company has revised 2017 guidance for earnings to be around $160m, down from "mid $170m" previously.
Canaccord Genuity believes the fundamentals are positive, as childcare is a relatively defensive industry where supply is moderating and demand is likely to benefit from an increase in government funding.
The main problem areas for supply were western Sydney, Gold Coast, east Brisbane and inner Melbourne, which comprise 73% of the downgrade for 2017. Canaccord Genuity estimates the revised guidance, reflecting the past three months of trading, suggests a -1.5-2% decline in occupancy, beyond what was expected.
The other major contributing factor to the downgrade was a regulatory change that came into effect in NSW and Victoria on October 1, that ensured staffing ratios were met during staff breaks. This required agency labour to fill gaps but the issue is considered temporary. An additional $1m in staff development and training was also spent above what was factored into prior guidance, but is also expected to be a passing influence.
The share market reaction was overdone and this presents a buying opportunity, hence Canaccord Genuity, not one of the eight stockbrokers monitored daily on the FNArena database, has a Buy rating and $4.20 target. Going forward, strong double-digit growth in earnings per share is expected in 2018 and 2019. Moreover, a conservatively geared balance sheet means the company is able to grow via acquisition.
CLSA is on the same page, recommending buying on the weakness. A weak 2017 result was expected although the downgrade was larger than forecast. Timing suggests the company may have experienced a sharp deterioration in occupancy late in the year. Still, risk/reward remains to the upside, in the broker's opinion, amid changes in government funding and a strong development pipeline. CLSA, also not one of the eight, has a Buy rating and $5.40 target.
However, Deutsche Bank considers the downgrade reflects a notable loss of earnings momentum and retains a Hold rating on this basis, citing heightened uncertainty in the industry overall. On the positive side, the company has indicated its acquisition program is on track and the upcoming childcare funding package will be positive.
Ord Minnett does not believe the downgrade suggests any new systemic industry or company-specific issues. It could be argued guidance needs to be set more cautiously going forward but the broker does not believe this casts doubt over the investment thesis. Significant improvements in operating earnings and return on capital are expected over the medium term.
Given the reaction in the share price, down -23%, the broker agrees investors now have a second chance before earnings start to move higher, particularly from the second half. Ord Minnett estimates underlying operating earnings fell short of budget by around – $10-11m, or -5-6%.
Macquarie acknowledges valuation is undemanding but remains cautious, envisaging supply-driven earnings risks will continue into the first half. Industry dynamics are expected to improve after rebate changes from July 1 but the broker wants evidence of improved occupancy before becoming more comfortable with the outlook.
This is particularly so given the high sensitivity of the stock to occupancy changes. Macquarie estimates every 1% change in occupancy leads to a $10m change, annualised, in revenue. The broker assumes a similar level of occupancy in 2018 to 2017, with a weak first half and a stronger second half. The first half of the year is also seasonally weaker because children leave to start school in February.
The main driver going forward, Ord Minnett agrees, will be the absorption of the supply that has been added to the market over the next 18-24 months. The company expects average occupancy to now be around 77% in 2017, implying a -2.7% fall on 2016. Occupancy could be a challenge, but Ord Minnett does not believe the situation is any worse than previously communicated.
For Deutsche Bank, the downgrade also highlights the high leverage in fixed costs to occupancy movements and, given exit barriers for excess supply in the industry are high, the market assumption that occupancy will improve in the short to medium term heralds downside risk.
Childcare subsidies will be introduced on July 1 with activity and means testing. In the activity test the subsidy will be determined by the hours of activity. A childcare rebate of 50% that is currently not means tested will be replaced with a subsidy. The single subsidy will be 20-85% with no fee relief for families on incomes over $350,000 per annum.
The database shows two Buy and two Hold ratings. Consensus target is $4.13, suggesting 16.2% upside to the last share price. The dividend yield on 2017 and 2018 forecasts is 5.5% and 5.6% respectively.
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