G8 Education (GEM) announced takeover offer for Affinity (AFJ) post the earning downgrade for equivalent of $0.70 per share. The takeover battle was eventually settled with Anchorage Capital offer of $0.92 cents per share conditional on Anchorage achieving binding financial commitments.
Although G8 Education did not win Affinity Education takeover auction. It received a nice little premium on the 14.5% of the Affinity Education stake it owns. It initially disclosed 19.89% of AFJ shares in July during initial stake. We estimate it made close to $10 million pre cost by accepting the takeover.
1H 2015 Revenue was $304 million from Childcare centers which amount to $10.86k per spot. Margins are lower in the 1H of the year due to seasonality of the business where occupancy troughs in Jan/Feb when children leaves childcare for schools and new children starts childcare over the year.
GEM trades on an estimate current EBITDA of 7.5x based on current consensus estimates and assumed EBITDA margin. The value relative to the broader market can be attractive where the EBITDA yield is around 13%.
G8 Education has 33,402 license spots where it is currently 84% occupied. Using Full Year estimated EBITDA of $150 million, GEM earns $5.3k per occupied spot.
Acquisitions are accretive as typical off market transaction are in the mid 4.5x to 5.5x range. It just take time to execution the consolidation play and post AFJ we assume management will refocus on growing the portfolio.
Final Affinity takeover if 0.92 cents per share is the lower end of the Independent Expert Report range.
Unlike the Australian Banks which we see as ex-growth. We own GEM because of the growth in earnings and consolidation play.
1. Fragmented Sector
Childcare is a fragmented sector where differences between private and public market valuation of childcare operators provides an attractive opportunity. Goodstart is the largest non-profit operator with around 640 child care centres. GEM is the largest for profit operator in Australia with 457 centers as if June 30 2015.
If you can buy additional operators at a lower valuation than your own then all acquisitions are accretive. You will do this day in and day out until the discrepancy narrows.
Interesting picture from the bidder statement shows the highly fragmented nature of the childcare sector.
Source: G8 Education
The fragmented nature of the sector means there is room for a consolidation play as long as you are paying below the multiple you are trading. If the research is right where 83% of the sector are single site owners then it will take time for anyone to wrap up the sector.
There is room to run in this space especially for GEM which is one of the largest players. Post Affinity Education stake sale it will have capital to redeploy.
G8 Education also keep the brand of the acquired centers. Chart below shows the staple of brands it has. Although branding is not important at this stage of growth. We see future opportunity of creating a national and consistent brand.
Source: G8 Education
2. Regulatory Certainty and Future Childcare Funding
Recently announced reforms in childcare funding is positive on the early childhood education sector. The highlights of the proposed reforms create certainty in childcare support for families and supportive of sector growth from 2017 onward.
Childcare Reform Highlights
For families with combined earning below $65k. They will be eligible for up to 85% of the actual fee or the benchmark price. Importantly there will be no cap for total rebates at this stage verse status quo of $7.5k per child.
Families earning above $170k will be able to receive 50% of the childcare expenditure while still enjoy no absolute dollar cap.
The level above $185k with 50% rebate but total rebate capped at $10k per child.
The childcare reform will impose work requirement, means test and activity test (on a fortnight basis for families to receive childcare assistance.
There are however risks associated with a roll up play. Namely by nature, mergers and acquisitions comes with a number of integration, management and financing risks.
For GEM the important question is the ability to finance future acquisition without overburden debts which could mean equity issues or payment with shares. In order to make this manageable, acquisitions are grouped in small batches rather than one big bang.
Although barrier to entry is low for another rollup it play in the space. Affinity Education privatization has a silver lining where it limit the potential in future equity in acquisitions. This could potentially limit the competition for GEM. Being private, affinity would require restart of the process in building up capital, credibility with investors and management track record in the future. GEM with with scale, consistent funding from through drp participation and being one of the largest players will have a strong head start over the nearest competitor.
Interestingly the GEM has been growing overtime. One understated area of raising cheap equity financing is through dividend reinvestment plans.
GEM Dividend History
We think management is able to gradually to increase capital on issue overtime by virtue of enabling dividend reinvestment plans. G8 Education pays dividend quarterly which make sense to an extent where income is relatively consistent. Quarterly dividends means greater frequency of cash retained through DRP and reinvesting in acquisitions.
GEM has under performed the wider top 10 shares in the portfolio but the growth story has not changed and the undemanding valuation means we are not sellers. Will add position if it declines from here.
One risk we should keep an eye on is the increase in debt. This should be managed conservatively given a large portion of the balance sheet is intangible assets, the goodwill in each center. While gearing has inched up in GEM overtime. On a net debt basis after net out cash it looks alot lower. This is offset by the consistency in the cashflow in the business.
Interesting from the Affinity target statement noted that GEM capitalized acquisition costs. We feel this can be considered aggressive as amortization of acquisition costs overtime inflates earning.
From reviewing management remuneration couple things stood out. The management is incentivized to growth earnings and hitting specific EPS growth rates. While we agree management should be remunerated for performance, pure focus on EPS growth can override other business considerations.
Employee cost is one of the largest expense item for GEM. Potential headwind risk is the increase in labour cost. This is an issue that will come to the forefront as the reform is passed through the parliament.
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