Why G8 Education Shares (ASX: GEM) Are Facing Growth Headwinds

This article was originally published at MF & Co. Asset Management.
G8 Education Limited (ASX GEM), established in 2007, is the largest ASX listed childcare centre operator in Australia.   The childcare industry growth over the past few years has been contributed to rising government expenditure within the industry.

However, the possible pay rises and increasing numbers of new childcare entrants has lead to aggressive competition within the industry. It’s unclear whether GEM shares can maintain a competitive advantage and continuously grow its market share.

About G8 Education Limited

G8 Education provides quality care and educational services for children across Australia and Singapore. It has a huge market cap of $1.165 billion, compared to $213 million of Affinity Education Group Limited (ASX AFJ), and $95 million of Think Childcare Limited (ASX TNK), while Goodstart Early Learning Limited is not listed in ASX.

GEM stock has 516 childcare centres within its portfolio including a range of well-known brands, such as Bambino’s Kindergarten, First Grammar and Buggles Early Learning and Kindy. The company has a geographically diversified portfolio of 495 childcare centres in Australia and 21 in Singapore.

Growth via Acquisition

ASX GEM stock has the largest market share of 7.9% in the childcare industry, followed by Goodstart Early Learning Ltd with 7.2%. G8 grows its market share dramatically through a continuous acquisition strategy. The strategy enables G8 to acquire unlisted childcare centres with low margins and improve the performance of them to generate profits. The number of childcare centre increased rapidly from 175 in 2012 to 516 in 2017 through a series of acquisitions.

The sustainable acquisition activities are supported by G8’s strong free cash flow. G8 has a much stronger cash flow compared to peers in the industry. G8 has restructured its debt in the past 12 months, leading to a lower net debt/EBITDA and greater cash flow.

In 2017, China First Capital Group funded G8 through a $212.8 million share placement, enabling G8 to conduct further expansion of its business.

Due to GEM stock’s’ extensive acquisition activities, it has a huge number of childcare centres across a range of different brands, which makes the integration of work culture difficult. For example, the remuneration has a component of risk due to the challenge of setting performance targets and rewards for management. Additionally, due to the high attrition rate in the workforce, a large amount is spent on employee training and development.

Growth Expected In The Childcare Sector

With the $8.8 billion spending in subsidy in the next financial year from the federal government’s new Childcare Subsidy System, affordability of childcare for low-income families is expected to rise.

The new childcare subsidy is predicted to increase to $10 billion by 2020, and the growing number of women re-entering the labour force after childbirth looks to further increase the demand for childcare.

The supply of childcare increases rapidly due to low entry requirement of the industry. The number of approved childcare services has risen from 11,277 in 2007 to 18,318 in 2017.

It’s predicted that the industry supply will continue to increase by 10% in the next 2 to 3 years, while the demand growth would only be 2% to 3%, the competition within the industry is aggressive, and GEM stock market share may be diluted by new entrants.

In spite of GEM stock’s great market share, it does not have a strong capacity to compete with those new entrants in the competitive environment, due to high costs and spending on employee training and development.

While the average hourly rate of childcare educators is $21.29 per hour the industry is campaigning for a 30% pay rise, which may lead to further pressure on the cost structure of G8.

ASIC’s investigation into former G8 Chair Joan Huston

Recently, the Australian Securities and Investments Commission conducted an investigation into G8’s failed takeover bid for Affinity Education in July 2015.

Jennifer Joan Huston, the former chair of G8 resigned in October 2015, is currently facing charges from ASIC for misleading behaviour and dishonest use of her position in the bid.

Although GEM shares has made an announcement stating that no allegations have been made against the company, the charges could result in contingent liability for G8 in the future.

Dividends decline to 10 cents per half year

G8 Education stock paid dividends of around 8% and maintained 24 cents per share a year for two years.

On February 23, G8 Education shares announced that the half-year dividend payment would be 10 cents, which is a decline compared to 6 cents quarterly in the previous two years.

After the announcement, the stock price of ASX GEM shares dropped from 3.15 to 2.9 by 7.94%. The response of the market demonstrates that the expectation of the market to the dividend is higher than the announced number.

Acquisition costs are an important part of G8 Education during acquisition of education centres, which means it’s unlikely to reach the desired earning per share as a result of high dividend payment.

To gauge the affordability of dividend, the company made the payment by cash flow, which may limit its ability to grow earnings by acquiring new education centres and reinvesting in the current centres.

Therefore, the 10-cent dividend per half year is likely to be unsustainable without any improvement of profit and G8 Education will probability cut its dividend again in the future.

Revenue growth and PE ratio of G8 Education Shares

The revenue growth of ASX GEM shares has been decreasing year-on-year from 2014 and around 1% in 2017. The revenue growth and current P/E ratio are both around the peer median, which shows high correlation of the historical data and the future long-term expectation.

G8 Education (ASX GEM) Revenue

PE ratio of ASX GEM shares was flat in the previous four years but lower than the average level in the industry and touched a new low at 13.86 since 2013 in 2017.

G8 Education (ASX GEM) PE

Moreover, G8 Education shares ROE was at its lowest compared to the last four years and it’s below the peer median rate (10.8% compared to 24.7%), which shows the inefficient capital use. The above fundamental analysis gives an overview that the company is losing potential.

ASX GEM Shares Will Have Major Growth Headwinds

G8 Education shares is still the company with the highest share of the childcare education market in Australia, but it is restricted by its running strategy and limitation of the industry. The share underperformed after the company update on trading performance, ASIC investigations into the former Chair Joan Huston and poorly received leadership team changes.

This article on G8 Education is written by Henry Fung, Managing Director at MF & Co. Asset Management, a boutique investment firm based in Sydney, Australia. For MF & Co.’s full website and further articles follow the link: MF & Co.

Categories: Australian Stocks, Featured

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