After G8 Education Ltd's (ASX: GEM) poor results two weeks ago spooked the market, I had a more in-depth look at the company's operating history. In particular, I wanted to see how the company contained its costs over the past five years, to see whether February's blow-out was an aberration or the norm.
These are my findings:
As we can see from the above, G8's employee expenses as a percentage of revenue have remained consistent at just under 60% of revenue from continuing activities. In fact, despite the recent rise which so spooked shareholders, G8 spends less on employees (per dollar of income) than it did five years ago.
Coincidentally, G8 also spends less in this sense than minnow Think Childcare Ltd (ASX: TNK), which rose strongly after G8's results.
G8's occupancy costs have remained constant at around 12% of revenue over the past five years, while direct costs of providing services have risen from 7.1% of revenue in 2011 to ~8% of revenue in the past few years.
(Depreciation and Finance costs as a percentage of revenue are not very useful statistics that I've included for my own interest, as an illustration of how company costs in these areas might have changed.)
G8 depreciates its assets quite rapidly due to their relatively short useful lives (2-15 years for furnishings) but as it doesn't have a lot of assets this isn't a significant expense. A better way to view depreciation might be depreciation as a percentage of Property, Plant and Equipment ("PPE"):
I also wanted to check the company's expenditure on Property, Plant and Equipment to see if they had been under-investing in their centres in recent years. Here's another chart showing payment to suppliers and employees and PPE expenditure as a percentage of receipts from customers (cash inflows) over the same time frame:
We can see that payments to staff and suppliers as a percentage of receipts from customers fell as low as 76% in 2015, before increasing to 83% in 2016.
Payment for property, plant, and equipment has remained constant at 3.1% of receipts in the past 18 months. This is below levels of 3.3% and 3.8% in 2014 and 2013, but well above 2.7% and 1.7% in 2011 and 2012.
We can see that G8's costs have been pretty constant in recent years and it doesn't appear that they have been under-spending compared to what they spent previously. However, how their spending compares to competitors is also worth examining. Since the departure of Affinity from the ASX, there aren't many major childcare operators remaining.
Think Childcare is just a guppy, but by way of comparison its employee expenses as a percentage of revenue were 62% in 2015, and 66% in 2016 – well above G8's. Occupancy costs as a percentage of revenue were 12.3% and 12.8% over the past two years, slightly above G8. Think Childcare also experienced significantly less depreciation both as a percentage of revenue and of PPE compared to G8. In terms of reinvesting in its centres, Think Childcare spent 2.3% of receipts from customers on PPE in 2015, and 3.9% in the first half of 2016, compared to G8's constant 3.1% over these two periods.
Evolve Education Group Ltd (ASX: EVO) just completed its first full year of operation and reported employee expenses of 54% of revenue – although, this company is domiciled in New Zealand which may have different wage and rental dynamics (and childcare regulations) to Australia. Evolve's depreciation was about on par with G8's. Evolve spent 1.7% of receipts from customers on PPE in 2016 compared with G8's 3.1%.
What does it all mean?
Congratulations for sticking with me thus far. In short, I couldn't see any suggestion in the above information that G8 has struggled to keep costs in line over the last five years. Apart from an aberration in February (caused by a regulated increase in staff to child ratios) G8 has managed to keep its costs remarkably consistent since 2011.
What's more, its costs compare favourably or are at least on par with other players in the market. Although G8 does have a lower wage expense, staff ratios are controlled by regulation and I couldn't see anything in the above that might suggest the company has been under-investing in its centres. Thus it's tough to argue that G8 has lower quality centres than Think or Evolve, at least based on their spending levels.
Occupancy levels also appear comparable. Although I wrote at the time of the results release that occupancy figures were not presented, I later emailed management and they informed me G8's occupancy in August was 82%, which is roughly in line with what Think Childcare (80.1%) and Evolve Education (87%) reported.
The bear case for G8
I'm not saying that G8 will or won't be a good (or bad) investment going forwards. There are a number of other potential ways the company could theoretically come unstuck, including cash flow and refinancing issues, write-downs on under-performing centres, over-paying for centres, and poor centre performance/lower occupancy levels (which would hurt earnings per share and dividends). Changes to the government's childcare rebates are also a real possibility. Furthermore the data provided above is historical, not forward-looking.
There's some suggestion that G8 is already experiencing headwinds in its centre performance, with Earnings Before Interest and Tax (EBIT) only growing 1% for centres acquired in 2014 and 2015. This is drastically below the growth experienced by centres acquired in earlier years. However, based on the data above, I don't think G8's costs and ongoing expenditure are unusual compared either to its past behaviour or to competitors.
Some fund managers are sceptical, and have compared G8 to the now-defunct ABC Learning. Brokers remain divided on G8, with Reuters reporting that 4 rate it as a 'Buy' (down from 5 a month ago), 1 says 'Outperform', 3 say 'hold', and 1 calls it a 'Sell'.
