Investors must pay greater attention to industry supply, particularly when the global bull market is at or near its end and global growth is close to peaking. Owning the number three or four player in an oversupplied industry can be a portfolio killer.
Market commentators and analysts tend to focus much more on demand: we hear a lot about Asia’s middle-class consumption boom and what it means for minerals demand; or Australia’s population boom and housing demand. Far less considered is the supply of those resources.
Also, economists focus on supply mostly as a price determinant: all things equal, greater supply of a product or service when demand is constant leads to lower prices.
Product oversupply has other consequences. In childcare there is talk that more parents are cancelling childcare over summer because they know places are available next year. When supply was tight, some parents paid fees over summer to reserve their child’s spot.
Product quality is another issue. Consider media, another vastly oversupplied industry. It’s obvious that content quality, in aggregate, has fallen because there is so much more of it. Retail service standards continue to fall and judging by studies of investment returns, it’s clear there are too many wealth-management firms and not enough truly skilled fund managers.
Oversupply can also create irrational market behaviour. A smaller player that has expensive, underused assets makes silly decisions that hurt competitors. That’s true in retailing, when some firms almost give away product during never-ending discount sales.
Industry oversupply is not all bad. Highest-quality firms in an industry that are best placed to weather periods of oversupply can snap up good assets at lower prices. That’s true in mining, where BHP Billiton and others with tier-one assets emerge stronger from downturns.
Also, earnings growth can quicken as demand/supply returns to equilibrium. Companies that suffer when the industry is oversupplied, prosper as new supply is turned off, demand starts to build again, and margins and earnings grow. That could be childcare in the next few years.
Improving medium-term outlook for childcare sector
Like other oversupplied industries, childcare had a great story to tell. Strong population growth meant rising demand for childcare, as did higher participation of women in the workforce and more women returning to work earlier after childbirth. Families having fewer children and spending more on early learning was another driver.
Then reality struck. A rush to open childcare centres began in 2013 and took several years to play out. Too many centres opened and too many childcare places became available. There were not enough kids aged below four to fill all the spots that had suddenly emerged.
Industry experts said occupancy rates averaged around 75% across the industry. No company can afford to have a quarter of its asset base sitting idle, particularly one such as childcare that has large fixed costs and high industry entry and exit barriers.
High childcare fees and a plateauing of the Federal Government’s childcare rebate for several years, also weighed on the industry. As industry supply increased, more parents looked for cheaper options or were able to move kids to different centres.
Sector leader, G8 Education(GEM), fell from $5.35 in mid-August to $2.05. Smaller rival Think Childcare (TNK) slumped from $2.48 in early 2017 to $1.16. Newly listed operator Mayfield Childcare (MFD) is trading below its $1 offer price at 85 cents.
Childcare centre owner ARENA (ARF), a Real Estate Investment Trust (REIT) I have written on favourably for The Switzer Super Report over the past five years, has mostly held its gains. ARENA’s five-year annualised total return (including distributions) is 20%.
That’s the bad news (ARENA excluded). The good news is there are signs that industry oversupply is slowly being resolved and industry growth rates are still good.
Business forecaster IBISWorld expects annual revenue growth of 4% over 2019 to 2014 in the childcare services industry in Australia. That’s down from 6.6% annual growth in the previous five years but plenty of industries would be happy a similar future growth rate.
Regulatory change is another positive. From July 2 this year, the new Federal Government Child Care Subsidy replaced the previous Child Care Benefit and Child Care Rebate. The new single subsidy is paid directly to childcare operators, meaning better flexibility and less regulatory burden. Simply, the change should make it a little easier for parents who have kids in childcare.
IBISWorld expects overcapacity issues in childcare to ease in the next five years and for government reforms to boost demand that helps absorb excess supply faster. G8 Education says supply of childcare centres will be “more in balance” by mid to late 2019. Tightening of bank lending to childcare property developers is slowing construction in the sector.
Still, the issue is not as clearcut as it seems: excess supply can be hard to unwind in childcare because struggling operators are often reluctant to leave the industry because of the high fixed costs in building centres.
Also, a record number of childcare centres have opened in Victoria alone in the past 18 months, some reportedly empty at their opening. Occupancy rates in the childcare industry could worsen before they improve and investors should not expect a rapid recovery. Industry conditions remain immensely challenging.
G8 Education the pick of childcare stocks
The question is whether childcare valuations have over-reacted to excess market supply, if there is too much gloom factored into prices, and if investors are looking backwards, rather than focusing on the potential for industry recovery in the next few years.
That looks to be the case with G8 Education, Australia’s largest commercial early-education provider with about 500 centres. The former market darling badly lost favour after reporting its interim profit in August.
Underlying earnings (EBIT) fell 21% in the first half of CY18 and margins contracted because of wage pressures and lower occupancy rates. A lower dividend payout policy was brought forward. Centre revenue growth was flat and investors reacted savagely. G8 Education’s one-year total return is minus 52%.
At $2.08, the market is valuing G8 Education on a forecast Price Earnings (PE) multiple of about 10, which is not demanding for a leading company in a sector that still has good long-term growth prospects as the population expands and more families need childcare.
The average PE for the S&P/ASX 200 index is a touch below 15, meaning G8 Education is trading at a significant discount to the broader market, assuming it meets broker earnings forecasts.
Morningstar’s fair value for G8 Education of $3.50 suggests it is significantly undervalued at the current price. An average forecast share price of $2.34, based on the view of 11 broking firms, also suggests G8 Education is undervalued.
I’m not as bullish as Morningstar, but even at the consensus view there is a sufficient margin of safety to buy G8 Education at the current price, provided one can hold it long enough to ride out the unwinding of excess industry supply, which is underway.
The childcare industry has had its share of disasters (i.e. ABC Learning Centre) over the years and can be volatile. It suits experienced investors who are comfortable with small and mid-cap stocks and regulatory risk.
Those with less risk tolerance, or greater need for income, should consider ARENA, a REIT I am still positive about. As a childcare property owner rather than operator, ARENA has a lower risk profile, but is not a pure play on childcare because it has properties in other sectors.
Chart 1: G8 Education
[1]Source: ASX
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor All prices and analysis at October 31, 2018.
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