Updated: Oct 28, 2018
As an owner/operator of four childcare centres and as a former equities equities analyst responsible for ABC Learning, I feel uniquely qualified to share my thoughts on the current woes of G8 Education. The key excuse provided by G8 for its profit downgrades is new supply. Though this is a factor, I believe there are more fundamental reasons such as G8's stretched finances and corporate business model, which also contributed heavily to the rise and fall of ABC. Time will tell if G8 will also succumb to ABC's fate.
Getting my start in childcare
‘Gee, you wouldn’t put your dog in here’ is a very clear memory I have of inspecting a childcare centre in the Christmas of 2008. The ABC Learning controlled centre was about to close and it wasn’t hard to tell why, the centre was disgusting. Not only were the resources old and dirty, but everything else as well including the floors, walls, outside playscapes and kitchen. My business partner and I gained control (it was cheap!) and set about cleaning and renewing the centre. On our first day we had five children and seven staff, who we quickly put to work cleaning. By the end of March 2009 our occupancy was 39% and by the end of November we were 75% full.
That was our second centre. Our first centre was bought nine months earlier from G8, then known as Early Learning Services (ELS). It was a totally different situation; the internal fit-out was basically brand new as ELS had bought it only twelve months earlier. However, at 34% occupancy the centre was spoiling the overall numbers of ELS’s upcoming float so it needed to be sold. Like the ABC centre, this one also required lots of TLC to get bookings up, something beyond the skills and interests of a listed company.
Seeing firsthand how these companies approached childcare was interesting, though not unexpected as this was a large part of our motivation to enter the industry – we believed there was an opportunity to provide genuine customer service to families. One of the first things we did was to remove wages expense from the weekly management reports. Staff make or break a childcare centre, so we didn’t want our manager focused on wages cost, but instead how we could use our staff to increase occupancy, and ultimately, profitability.
G8’s fundamental problem
G8 and other large corporate childcare providers have a fundamental problem: parents know that such businesses are run first and foremost for profit. They want to leave their precious child with peace of mind that he or she is having fun, eating quality food, playing nicely with friends in a supervised and safe environment, sleeping when needed and learning about the world. They don’t want care of their child being compromised by an incentive to reduce costs and maximise profit.
We are also in the business to make a profit. However, it’s somewhat different for listed childcare businesses because of the constant pressure to maximise profit, now and into the future. This is not unique to childcare, but the business is more vulnerable than most to long term damage inflicted in the pursuit of short-term profit. It takes strong leadership to resist this pressure.
As a private operator, we can make decisions that consciously lower short term profits but increase long term profits. One example is to hire more experienced and therefore more expensive educators. Our wage costs are higher but better care for the children leads to happy parents which leads to higher occupancy and profits. Our families will also tell their friends that we have fantastic and stable staff and lift our reputation in the community.
Least preferred option
Due to the image problem described above, large corporates require optimum conditions to achieve high occupancy. That is, if a parent has a choice, a large corporate is generally the least preferred option. Optimal conditions include an undersupply of centres and convenient access.
So, understanding this, G8 and other large corporates are forced to pay up for centres that have optimal conditions. Not only is the purchase price greater, the centres are likely to have much higher relative rents due to their premium locations.
However, owning centres in premium locations only slows down and delays the inevitable decline in occupancy as parents seek alternatives to a large corporate operator. One of the reasons for this is that G8, and ABC Learning previously, are often targeted for new supply. When we first started in childcare we would look for new centres that were close to an ABC because we knew that we would easily provide a better service and therefore become the first choice for parents in the area.
Business model depends on growth
As it’s only a matter of time before occupancy at a large corporate owned centre starts to fall, an acquisition or ‘roll up’ strategy is required to maintain and grow profits. A conveyor belt is created whereby centres are bought at a high level of occupancy, say 90%, and are then milked for as long as possible until they are ultimately sold or closed when occupancy has declined to a point where a great deal of time, effort and money is required to lift a centre back to its former level. Profits initially increase as costs are reduced, and are then maintained by raising prices, but ultimately fall on lower occupancy.
Growing through acquisition is also crucial to the G8 business model because it creates value through an arbitrage between private business values and listed company valuations. As a rule of thumb, childcare centres trade on a multiple of four times underlying profit (EBIT), however, companies such as G8 can trade on a multiple equivalent to 10-15x EBIT. So, without doing anything other than changing ownership, G8 can turn $1m in operating earnings for which it paid $4m, to $7m in new market value.
Childcare is a great industry for this magic trick because ownership is very fragmented, even after aggressive buying sprees, the five largest players only control about 20% of the 7,300 childcare centres in Australia. The problem is that once the music stops the declining performance of the underlying businesses are exposed and the market reacts savagely.
Falling revenue and high fixed costs don’t mix
Childcare businesses have a high proportion of fixed costs because the two largest expenses are wages and rent (68% combined in 2017 for G8). Rents typically increase 3% every year and wages are also relatively fixed due to Australia’s restrictive industrial relations laws. Therefore, as like for like occupancy falls due to declining occupancy levels, profitability decreases rapidly if not offset by acquisitions and/or price rises.
A typical childcare centre will be unprofitable below 70% occupancy, so G8’s average occupancy of just 70.1% in the first half of 2018, down 2.5%, is worrying. G8 is not consistent with its reporting of like for like occupancy, but average occupancy appears to have peaked at about 85% in 2014.
In its latest half year result to June 2018, G8’s cash flow statement reported outflows of $29m for new acquisitions and $31m for dividends. Combined, this was double its cash inflow of $30m. The difference came from debt, which increased to $344m.
Due to its rapid expansion and high dividend payout ratio, G8 has consistently used debt and equity to finance its business model. This works really well when profits are expanding and markets are working, but there’s no slack in the system should its share price collapse and/or debt markets freeze. ABC Learning was one of the first casualties of the GFC in Australia because it couldn’t raise new capital. The underlying businesses were profitable and are still going strong in the form of Good Start.
At its half year profit announcement G8 reported that it had refinanced $270m worth of bonds that were due to expire in May next year. Hopefully for G8 shareholders this is finalised before the lenders change their minds like the three potential purchasers of the portfolio of 170 centres owned by Affinity apparently did after G8’s disappointing profit result.
It’s true that falling interest rates have encouraged many residential investors to try their hand at building childcare centres with a new wave of supply remarkably similar to 2007-08. Operators have been all too keen to sign lease agreements with large rents knowing that a new centre will attract families. It especially affects existing centres that haven’t been refurbished in 15+ years and look old and tired in comparison. We have witnessed this too – we recently opened a new centre that quickly achieved 90% occupancy, whilst a nearby Affinity owned centre trades at less than 30%.
However, childcare customers are quite sticky, which slows down the effect of new competition. Children settle in and cope better when things are stable, so changing centres is something parents try to avoid. Generally, it’s quite a serious decision for parents to move their child to another centre. It is also why prices are relatively inelastic, moving a child to save a few dollars is uncommon.
Another quirk of childcare also slows down the loss of occupancy to new supply – bookings are limited to a centre’s licensed places. Unlike other businesses like JB Hi-Fi or Bunnings, a new and better entrant will not wipe out all its nearby competitors. It will just take the first tranche of children, and then the next best will take the next tranche and so on.
G8 expects the pace of new supply growth to slow because developers are finding it more difficult to get finance. We’ve been speaking with many developers lately for joint ventures and the conversations are certainly much different to what they were a year ago when we would have to bid huge rents and key money (money paid to the developer for the right to operate the centre) to get the deal.
Press articles have concentrated on oversupply as the cause of G8’s problems. This is true, but only to an extent. I believe that oversupply, like the tightening of credit markets or its slowing expansion, has only accelerated an inevitable decline. This is therefore quite likely not the temporary issue that G8 and market commentators suggest but something more fundamental. If G8 cannot improve its finances and resume acquisitions it will continue to struggle and most likely, fail.
TS 11 September 2018