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A Value Investor’s Guide to G8 Education Ltd – Part II

A week ago I took a look at G8 Education Ltd’s (ASX: GEM) costs and depreciation both compared to its historical norms, and compared to other competitors on the ASX. I found that by and large, G8’s costs had remained relatively stable until the sharp rise in costs that rocked shares a few weeks ago.

The previous article in this series looked at the company’s base, trying to determine if G8 had been poorly managed or under-investing in its own centres. As we saw, the figures weren’t conclusive. Today’s article looks at the actual operation of G8’s centres, their occupancy levels and the company’s profit margins.

source: Company presentations

Source: Company presentations

As we can see from the above graph, G8’s Earnings Before Interest and Tax (EBIT) margins, also known as ‘operating profit’ margins have risen steadily in past years (higher is better) partly due to rising occupancy, fee increases, and lower costs. Due to the high fixed costs of the childcare business the recent increase in labour expenses combined with lower occupancy (more on this below) have been sufficient to virtually halve profitability in the first half of 2016, compared to the previous year.

I have included both Net Profit After Tax (NPAT), the statutory figure, as well as Underlying Net Profit After Tax (UNPAT), which excludes one-off costs like acquisition costs and so on. In any case we can see that the margins for both mirror each other quite well. Underlying EBIT (“UNEBIT”) margins also mirror EBIT margins quite well.

When looking at this graph, investors must remember that G8’s business is seasonal with earnings weighted to the second half of the year – which is the February half, since G8 reports on a calendar year basis. It’s less appropriate to include half-year results alongside the full-year figures, but the first half of 2016 (“1H16”) are the most recent results available which is why they are included.

Making the money

There are many things that can affect profit margins. The most obvious one is occupancy – the percentage of G8’s total places that are utilised on average. Caring for less children results in fewer fees as well as a disproportionately rapid drop in profit because costs are fixed.

Here is a chart of G8’s occupancy (yellow line) alongside its margins:

source: Company presentations

source: Company presentations

Although G8’s occupancy appears to remain fairly consistent at above 80%, figures were not consistent and there were times when I had to calculate average occupancy myself, or rely on management’s reported occupancy level which didn’t always have a specific definition. An example of this is where management reports Like-For-Like (“LFL”) occupancy (which excludes centres acquired in the current year) at one time, but at another time they’ll report ‘occupancy was XX%’ without clarifying. Additionally, sometimes occupancy levels weren’t disclosed at the same time every year, so I might have, for example, compared average occupancy reported in August with occupancy in February.

Thus, looking at these figures alone, there could be a significant amount of variance ‘hidden’ within them. However, if you look at expenses as a percentage of revenues in part 1 we can see that in percentage terms these expenses fall in the same years as G8 reports high occupancy. This supports the case that the occupancy figures above are reasonably accurate.

So What? 

Fluctuations notwithstanding, so far G8 appears to be a profitable investment, with sustainable margins. The recent decline in profit in 2016 was due to legislated labour cost increases as well as seasonally lower occupancy.

Why did occupancy rise from 2012-2015 and then fall in 2016? Frankly, I have no idea.

Part of the explanation is that 2016 is only a half year, and as I mentioned earlier G8’s business is weighted to the second (current) half of the year. Occupancy thus should improve in the second half. Another theoretical explanation could be that at several times, when it was smaller, G8 was acquiring centres with occupancy levels of 95%. These would have caused average occupancy levels to rise – one might infer that fee increases, poor centre quality or poor management have subsequently driven group occupancy down. However, that also could be inaccurate because at the same time as it was acquiring these high-quality centres, G8 was also grappling with a number of under-performing centres.

With that said, 40% of G8’s current number of centres were acquired in 2014, but excluded from the 2015 occupancy figures. These centres will be included in occupancy calculations for the first time in 2016 and are significant enough in number that if acquisitions are affecting G8’s average occupancy we should be able to see the effect.

Ultimately it’s very tough to establish which it might be – and anyway, occupancy is far from the only measure of the company’s success.

Further considerations

There are many other things to bear in mind with G8. Key issues are fees, government support of the sector, demand for childcare, the group’s balance sheet, the price it pays for acquisitions and, – not least of your concerns – the risk that a man that goes looking for an explanation in raw data will find (or manufacture) one.

At the end of the day, none of the above tells you whether G8 is a buy or not. I do consider that it has alleviated some of the bear case for the company, though investors will now be eagerly waiting for the full-year results in February. Expect a follow-up article in coming weeks with a closer look at G8’s fees and the price it pays for acquisitions.

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Motley Fool contributor Sean O'Neill owns shares of G8 Education Limited. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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