G8 Education - Morgans

Education│Australia│Equity research│March 13, 2018

G8 Education Transformation underway

ADD Current price: Target price: Previous target: Up/downside: Reuters: Bloomberg: Market cap:

A$2.75 A$3.53 A$ 28.5% GEM.AX GEM AU US$970.3m A$1,233m US$9.59m A$12.22m 445.7m 88.4%

Average daily turnover: Current shares o/s Free float:

■ GEM is a leading provider of ‘for profit’ child care and education facilities. ■ Recently, the group has renewed its key management team, reviewed its capital management strategy, raised new equity and is now focused on transforming the operating business and growing occupancy.

■ While recent industry challenges (oversupply/regulatory changes) have put pressure on occupancy/wages, taking a medium-term view, we believe the group is well positioned to grow via acquisitions, organic growth, and improved operational efficiencies with a more stable regulatory and supply backdrop.

■ We initiate coverage with an Add rating and A$3.53 price target. Following a recent de-rating GEM is trading on a FY18 PE of 11.8x and a dividend yield of +7%.

Largest ‘for profit’ child care operator GEM is a ‘for profit’ provider of child care and education facilities across Australia and Singapore (c8% market share with 516 centres). GEM operates 23 brands. Key demand drivers include population growth in children aged 0-4 years (c6.5% of population); growth in workforce participation/rate; supportive government funding; and favourable economic conditions (eg wages growth, higher discretionary income).

Price Close

Relative to S&P/ASX 200 (RHS)

5.00

119.0

4.50

107.0

4.00

95.0

3.50

83.0

3.00

71.0

2.50 30

59.0

Vol m

20 10 Mar-17

Jun-17

Sep-17

Dec-17

Source: Bloomberg

Price performance Absolute (%) Relative (%)

1M -14.6 -17.6

3M 12M -21 -31.3 -20.7 -35.1

Fiona BUCHANAN T (61) 7 3334 4879 E [email protected]

Transformation underway, acquisition opportunities on agenda Recently GEM has undergone renewal from a management/board and operational perspective. Operationally, key focus areas we expect to contribute to the transformation include the impact from a new CRM; a review of pricing strategy; churn/conversion; costs; marketing; staff training; and brand consolidation. The group also undertook a comprehensive capital management review in 2017 which resulted in a stronger balance sheet; improved debt funding; and reduced gearing levels, ensuring it is well placed to participate in industry consolidation and fund the roll out of its development pipeline.

Result misses, reflecting a challenging 2017 GEM delivered FY17 EBIT of A$156m (vs A$160.7m in the pcp), which was 3% below its downgraded guidance of cA$160m. Fee increases were largely offset by weaker occupancy due to continued pressure from oversupply/macro. LFL occupancy for FY17 was 76.7% (-3% vs the pcp). GEM noted that occupancy in January has been relatively stable with committed bookings ‘heading in the right direction’ (although occupancy is still down vs the pcp). Market conditions are expected to remain challenging in 1H18 (largely supply driven, however supply expected to moderate), although the Federal Government’s “Jobs for Families” Child Care Package (starting July 2018) is expected to drive demand (likely to see evidence 2H18/1H19 – pricing/improved occupancy).

Initiate with Add rating: recent de-rating an opportunity We value GEM at A$3.53 based on a blended DCF, PE and EV/EBITDA valuation. GEM is trading on a FY18F PE of 11.8x (vs XSO at around 17x) and offers a +7% dividend yield. Catalysts relate to positive trading updates (1H18 result due August); acquisitions; evidence of success stemming from operational efficiencies/economies of scale; and positive outcomes from the new Government childcare funding (pricing/occupancy). Key metrics Revenue (A$m) EBITDA (A$m) EBIT (A$m) NPAT (A$m) EPS Norm. (cps) EPS growth Normalised P/E (X) DPS (cps) Yield Payout ratio Net debt/EBITDA (x)

Dec-16A 775.0 172.4 160.7 93.3 24.7 n/a n/a 24.0 4.8% 97% 2.2

Dec-17A 789.0 170.0 156.0 92.9 21.8 -11.7% 12.6 18.0 6.5% 83% 1.5

Dec-18E 873.9 188.7 172.0 105.0 23.3 6.8% 11.8 20.0 7.3% 86% 1.7

Dec-19E 969.6 217.2 198.5 124.0 27.2 16.8% 10.1 21.1 7.7% 78% 1.7

Dec-20E 1061.8 244.2 222.5 139.6 30.3 11.4% 9.1 22.7 8.3% 75% 1.6

SOURCE: MORGANS, COMPANY REPORTS

IMPORTANT DISCLOSURES REGARDING COMPANIES THAT ARE THE SUBJECT OF THIS REPORT AND AN EXPLANATION OF RECOMMENDATIONS CAN BE FOUND AT THE END OF THIS DOCUMENT. MORGANS FINANCIAL LIMITED (ABN 49 010 669 726) AFSL 235410 - A PARTICIPANT OF ASX GROUP

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Figure 1: Financial summary Profit and loss Revenue Other revenue Total Operating Costs EBITDA Depreciation Amortisation & impairments EBIT Net Interest Income Pre-tax Profit Tax Normalised NPAT Adjustments Reported NPAT

FY16A FY17A FY18E FY19E FY20E 775.0 789.0 873.9 969.6 1,061.8 2.5 6.7 0.0 0.0 0.0 -605.1 -625.8 -685.2 -752.4 -817.6 172.4 170.0 188.7 217.2 244.2 11.7 14.0 16.7 18.7 21.7 0.0 0.0 0.0 0.0 0.0 160.7 156.0 172.0 198.5 222.5 -32.9 -27.3 -22.1 -21.4 -23.1 127.8 128.7 149.9 177.1 199.5 34.4 35.9 45.0 53.1 59.8 93.3 92.9 105.0 124.0 139.6 -13.1 -12.3 0.0 0.0 0.0 80.3 80.6 105.0 124.0 139.6

Valuation details Share Price Price Target Total shareholder return

$2.75 $3.53 35.0%

DCF valuation WACC RFR MRP

$3.72 10.1% 3.8% 6.0%

EV/EBITDA valuation

$3.43

PE valuation

$3.26

Cash flow statement EBITDA Net interest Tax Changes in working capital Operating cash flow Capex Free Cash Flow Acquisitions and divestments Other Investing cash flow Investing cash flows Increase / decrease in Equity Increase / decrease in Debt Dividends paid Other financing cash flows Financing cash flows

FY16A FY17A FY18E FY19E FY20E 172.4 170.0 188.7 217.2 244.2 -24.2 -25.2 -22.1 -21.4 -23.1 -35.0 -34.1 -45.0 -53.1 -59.8 -4.6 -13.5 4.9 5.5 5.3 108.6 97.2 126.6 148.2 166.7 -25.0 -18.4 -27.0 -25.0 -25.0 83.6 78.7 99.6 123.2 141.7 -66.7 -67.4 -120.0 -80.0 -80.0 -15.5 -0.4 0.0 0.0 0.0 -107.1 -86.2 -147.0 -105.0 -105.0 6.5 200.7 17.2 18.6 19.1 -101.9 -111.2 50.0 25.0 25.0 -58.0 -62.8 -72.5 -94.1 -101.5 -15.6 -9.7 0.0 0.0 0.0 -168.9 17.0 -5.3 -50.5 -57.4

Key metrics/multiples P/E Yield PEG EV/EBITDA Operating cash flow yield Free cash flow yield EBITDA Margin (%) EBIT Margin (%)

FY16A n/a 8.7% n/a 8.3 8.9% 6.8% 22.2% 20.7%

FY17A 12.6 6.5% -1.1 8.8 7.9% 6.4% 21.5% 19.8%

FY18E 11.8 7.3% 1.7 8.4 10.3% 8.1% 21.6% 19.7%

FY19E 10.1 7.7% 0.6 7.5 12.1% 10.1% 22.4% 20.5%

FY20E 9.1 8.3% 0.8 6.8 13.6% 11.6% 23.0% 21.0%

Per share data Shares on issue EPS (A$) DPS (A$) Payout ratio

FY16A 382.5 0.247 0.240 97%

FY17A 448.5 0.218 0.180 83%

FY18E 453.5 0.233 0.200 86%

FY19E 458.5 0.272 0.211 78%

FY20E 463.5 0.303 0.227 75%

Balance Sheet Assets Cash And Deposits Debtors Inventory Other current assets Total Current Assets Fixed Assets Investments Goodwill Intangibles Other non-current assets Total Non-Current Assets TOTAL ASSETS

FY16A FY17A FY18E FY19E FY20E Result quality Cash flow conversion FCF vs NPAT Gross dividends vs FCF

FY16A 97% n/a 69%

FY17A 92% 98% 80%

FY18E 103% 95% 73%

FY19E 103% 99% 76%

FY20E 102% 101% 72%

Gearing Net Debt Net Debt / Assets Net Debt / EBITDA (x) EBIT interest cover (x) Invested Capital Enterprise Value

FY16A 384.2 32.7% 2.2 4.9 1,005 1,436

FY17A 254.3 19.7% 1.5 5.7 1,106 1,488

FY18E 330.0 23.6% 1.7 7.8 1,250 1,577

FY19E 362.3 24.4% 1.7 9.3 1,331 1,623

FY20E 383.0 24.3% 1.6 9.7 1,409 1,658

Growth ratios Revenue Operating costs EBITDA EBIT NPAT EPS growth DPS growth Operating cash flow

FY16A 12.8% 13.4% 11.4% 10.5% 5.4% 3.4% 0.0% 35.6%

FY17A 1.8% 3.4% -1.4% -2.9% -0.5% -11.7% -25.0% -10.5%

FY18E 10.8% 9.5% 11.0% 10.2% 13.0% 6.8% 10.9% 30.3%

FY19E 10.9% 9.8% 15.1% 15.4% 18.1% 16.8% 5.5% 17.1%

FY20E 9.5% 8.7% 12.4% 12.1% 12.6% 11.4% 7.8% 12.4%

Key metrics No of centres No of licenced places Occupancy (LFL)

FY16A 510 38,713 79.9%

FY17A 516 40,561 76.7%

FY18E 546 44,161 76.7%

FY19E 566 46,561 78.0%

FY20E 586 48,961 78.5%

26.5 49.2 23.4 16.2 20.5 22.9 30.4 33.6 37.3 40.9 0.0 0.0 0.0 0.0 0.0 12.2 12.6 12.6 12.6 12.6 61.6 92.2 69.7 66.1 74.0 54.8 63.9 98.2 120.5 139.9 0.0 0.0 0.0 0.0 0.0 1,015.0 1,088.0 1,184.0 1,248.0 1,312.0 0.0 0.0 0.0 0.0 0.0 41.8 49.1 49.1 49.1 49.1 1,111.6 1,201.0 1,331.3 1,417.6 1,500.9 1,173.2 1,293.2 1,401.0 1,483.7 1,574.9

Liabilities Short Term Debt Creditors Other current liabilities Total Current Liabilities Long Term Debt Deferred tax Other Non current liabilities Total Non-Current liabilities TOTAL LIABILITIES

0.0 88.8 26.0 114.8 410.6 0.0 21.9 432.5 547.3

49.9 76.1 26.1 152.1 253.6 0.0 22.1 275.7 427.8

0.0 84.3 26.1 110.4 353.5 0.0 22.1 375.6 486.0

0.0 93.5 26.1 119.6 378.5 0.0 22.1 400.6 520.3

Equity Issued capital Retained earnings Other reserves and FX TOTAL EQUITY

641.8 -51.6 35.6 625.9

876.4 -55.6 44.6 865.3

893.5 -23.1 44.6 915.0

912.2 931.3 6.8 44.9 44.6 44.6 963.5 1,020.7

0.0 102.4 26.1 128.5 403.5 0.0 22.1 425.6 554.2

Market Cap A$1,225.6m

Dec y/e SOURCE: MORGANS RESEARCH, COMPANY

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INVESTMENT HIGHLIGHTS 

Attractive fundamentals following recent de-rate – following its de-rating (December trading update/earnings downgrade and recent FY result miss) GEM is currently trading on a FY18F PE of 11.8x (vs its long-term average of around 15.5x and the XSO of around 17x). It also offers an attractive dividend yield of +7%. We believe current challenges are more cyclical in nature (vs structural) and while they are likely to persist in the near term, taking a medium-term view, we see current fundamentals as an attractive entry point.



EPS growth – industry challenges (and a large capital raising) were the main contributors to a weaker FY17 EPS result (EPS -11.7% vs the pcp), we forecast three-year forward EPS CAGR of approximately 14% with growth underpinned by new acquisitions (funding in place), stabilised occupancy (supply moderation), pricing growth (impact from new Government funding) and improved operational efficiencies (eg new management team/CRM in place/better integration of large portfolio).



Growth via acquisitions – GEM mainly focuses on premium centres located in metro areas. The development pipeline stands at 49 centres with 30 greenfield centres projected to open in FY18 (A$120m cost/1H18 weighted) and 10 centres in FY19. We note it takes anywhere from 6 weeks to 6 months to reach break-even and then another 6-12 months to build up to optimal occupancy levels (ie minimal FY18 impact). Management noted that acquisitions undertaken in 2016 and 2017 are performing in line with expectations (A$15m EBIT contribution forecast for FY18).



Organic growth – the existing portfolio offers opportunities to drive occupancy and pricing growth. While oversupply was an issue in 2017 (occupancy down 3% at December 2017 vs the pcp) and is expected to remain challenging throughout 1H18, commentary from GEM and other peers (Folkestone Education Trust (FET), Think Childcare and Education (TNK)) suggests that supply is beginning to moderate with bank funding to operators and developers tightening. TNK also commented that it is seeing fewer centres under construction and fewer DAs being lodged, with the sector returning to more sustainable numbers. We also note that some of the occupancy moves in 2017 were due to internal issues (see below) so believe there is also scope for improvement internally (lower staff turnover, better conversion, etc) which will also assist. Management also noted that its high quality centres within the portfolio were not impacted where there was oversupply proving that focus on operating quality centres/providing ongoing investment is important. During 2017, GEM continued to invest capital into its centres (130 refurbishments or improvement activities completed) with 32% of centres being assessed as exceeding National Quality Standards.

Figure 2: Occupancy waterfall chart FY16-FY17*

*Other issues relate to internal issues (eg centres with lower than benchmark NPS and or quality ratings). SOURCE: COMPANY REPORTS

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

Well positioned to participate in industry consolidation – GEM has around 8% market share (we note the largest non-profit operator Goodstart Early Learning holds around 9% market share). It is expected the fragmented market will continue to provide consolidation opportunities over the medium term in which GEM is well positioned to participate. We note recent media reports suggesting that private equity backed Affinity Education Group is for sale. Affinity is one of the largest for profit child care operators with around 160 centres (vs GEM at 516 centres). If GEM were to look at acquiring the group it would require significant equity/debt.



Balance sheet strengthened – In 2017, GEM raised new equity and entered into a new bank facility ensuring there is capacity to fund its capex and acquisition pipeline. We estimate the interest coverage ratio is currently around 5.7x and gearing (debt/assets) is around 25%.



Strong cash flow conversion – child care centres typically generate strong free cashflow given the positive working capital cycles. While FY17 cash flow was weaker than the pcp, underlying cash flow conversion was 96% and we expect improved cash flow conversion in FY18.



Benefits of scale – we expect GEM can leverage its size and achieve economies of scale (eg compliance, regulatory or legislative changes) relative to smaller operators for capex and procurement. In FY17, other costs were A$3.2m lower than the pcp driven by procurement initiatives and marketing savings (management expects procurement savings of around A$2m in 2018). We note that an up skilling in staff, increased educator-tochild ratios and the implementation of educational programs have put pressure on costs for operators following recent regulatory changes.



Recent regulatory changes expected to be positive – from 2 July 2018, the industry’s operating conditions will change due to the government’s ‘Jobs for Families’ Child Care package (government funding expected to increase by around 20%). A new single Child Care Subsidy (CCS) will replace the existing Child Care Benefit and Child Care Rebate, with the new subsidy to be paid directly to childcare operators. Depending on income, the single subsidy will cover up to 85% of child care for some families with low income households receiving the highest benefit. It is expected industry players will benefit from increased flexibility and a reduced regulatory burden due to the reforms. Management expects the impacts to become evident in early CY19 and a key focus in the short term is how it will maximise the new funding package.



Starting to reap the benefits from a renewed focus on efficiency, cultural transformation and productivity – given the renewed focus on transforming the business, we believe GEM can leverage off improvement in operational performance, systems and technology (eg centralised call centre) to improve service and enhance families' experience. We note a new childcare management system (XPlor) will be implemented in mid 2017 which is expected to deliver greater visibility on a per centre basis and increased automation (eg enrolment forms). Management has said that a core part of this will be focusing on sourcing, retaining and developing quality staff (team turnover -1% in 2017). According to management, 2017 saw significant activities in three key cultural areas (embedding core values, training and engagement surveys). GEM also currently operates 23 brands which we expect to be consolidated over the medium term.



Executive team renewal – over the past 12-18 months there has been a range of new appointments across the group (MD/CEO, CFO, Company Secretary, GM Operations). Gary Carrol was appointed MD/CEO in January 2017 and is an experienced operator. The formation of an executive leadership group in 2017 reviews performance and appropriate resourcing to ensure optimal operational outcomes (refer to section on Board & Management for further detail).

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COMPANY OVERVIEW GEM owns and operates child care centres in Australia and Singapore. The group listed on ASX in December 2007 under the name Early Learning Services. In March 2010 it merged with Payce Child Care to become G8 Education. Since then it has also acquired Sterling Early Education (2014) and been highly acquisitive as illustrated in the chart below: Figure 3: GEM centres as at December 2017 and forecast 1H18

SOURCE: COMPANY REPORTS

It is the largest ‘for profit’ childcare player with a majority of centres in metro areas (NSW and VIC focus). It currently has 516 centres via 23 brands. Around 65,000 children attend its services each week with around 10,000 employees. Its current licence capacity is +40,000. Figure 4: Geographic breakdown as at December 2017 Singapore, 4% QLD, 14%

WA, 13%

SA, 5%

NSW, 36%

VIC, 26%

ACT, 2%


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Strategy re-set According to GEM, 2017 saw significant activities in three key cultural areas. Firstly, embedding its core values – Passion, Integrity, Compassion, Innovation and Dedication – across the group. GEM also conducted a formal engagement survey and implemented engagement actions plans to drive engagement across all teams. Finally, there was a focus on recruiting executive leaders and the establishment of senior leadership development programs to build leadership capability throughout the group. Figure 5: G8 Strategic Framework as at December 2017


December 2019 target – As outlined above, GEM has a strategic plan to reach revenue of A$1.2bn and EPS of 40cps. Our EPS forecasts currently sit well below the target but we consider this to be a stretch target rather than formal guidance.

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Brands GEM currently operates 23 brands in Australia; however, we expect these will be consolidated in the medium term (examples below). Figure 6: GEM brands


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COMPETITOR OVERVIEW Steady increases in government funding have driven much of the industry's growth over the past decade. Increasing attendance numbers have led to new players entering the industry and new childcare facilities to open, including long day care centres and family day care facilities. The industry has also been shifting towards providing educational services alongside child care services. According to the Australian Children’s Education & Care Quality Authority (ACECQA) there are around 7,231 long day care providers in Australia. As at 30 September 2017, 39% of approved child care services are provided by small approved providers (just one service) while 32% of approved services are provided by large approved providers who manage 25 or more services. Aside from GEM (c8% market share) the other major player includes ‘not for profit’ operator Goodstart Early Learning (c9% market share). Other players in the ‘for profit’ space include: Affinity Education Group (c2% market share) and Guardian Early Learning Group (c1.5% market share). Other listed ‘for profit’ child care operators include TNK (c0.5% market share) and Mayfield Early Education (MFD) (