Has GEM learnt lessons from ABC?

G8 Education (ASX: GEM) recently reported its first half 2016 results and the reading was not pleasant.  Revenue missed consensus estimates by 4.2 per cent and the earnings before interest and tax (EBIT) margin was 17 per cent against 19 per cent for the previous corresponding period.  More concerning was that for centres acquired before 2015, we estimate the like-for-like incremental EBIT margin was just 2.8 percent despite the fact that like-for-like revenue growth for these centres was 8 per cent thanks in part to a January fee increase.

For centres acquired before 2014, EBIT grew 17 percent between the first half of 2014 and the first half of 2015.  But for the same centres, EBIT only grew 0.7 percent between the first half of 2015 and the first half of 2016.  This represents a very significant deceleration.

In the first half of 2015 the EBIT of $59.4mln, for centres acquired before 2015, equated to an EBIT margin of 20.7 percent.  In the first half of 2016 EBIT had only grown by 1.1 percent to $60mln for centres acquired before 2015 and the EBIT margin had declined to 19.3 percent.  The increase in revenue between these two halves produced an EBIT increase of only $644,000 or an incremental margin of just 2.8 percent.  Another very significant deceleration.

Part of the reason for the deteriorating margins is a 10 per cent increase in wages thanks to the imposition of higher carer-to-child ratios that came into force on 1 January 2016.  In NSW, QLD and SA, ratios decreased from one teacher for every eight 2-3yr-old eight children to one teacher for every five children.

Another interesting aspect to the result and associated commentary was that management did not update their ‘guidance’ from the full year 2015 results announcement, in February 2016, when they forecast double-digit earnings growth.  Given that GAAP earnings declined by 16 percent in the first half (-3 per cent on and adjusted EPS basis) achieving a double digit full year result means the second half has to grow very strongly.  In fact, the implied second half GAAP earnings per share of 18.3 cents suggests 11 per cent YOY growth, which is optimistic given consensus growth estimates are flat for GAAP EBIT.  The market could be very disappointed.

Subtracting the GAAP EBIT of $60mln from Centre EBIT of $68.5mln provides an expected corporate cost of $8.5mln for the first half.  Performing the same calculation for the 2015 corresponding period, we arrive at corporate overheads of just $2.4mln.

Changes of such magnitude are a possible red flag because it suggests the cost allocation method between halves may have been changed, which seems unlikely given it is a fixed cost, or some of the centre operating costs have been allocated to corporate overhead.  If it was the latter, it could mean that the centres are even less profitable than the accounts suggest.

Another red flag for us is always the resignation of an auditor.  In November 2015 (effective May 2016) HLB Mann Judd resigned as auditor after six years.

If individual centres are suffering from margin compression or contraction more of the future revenue and earnings growth will depend on acquisitions.  But the rate of acquisitions is slowing.  In 2014 the company acquired more than 200 centres.  In 2015 that number was closer to just 50 and in 2016, only nine were acquired so far with an expected 12 in the second half.

Finally, in 2014 the company made the statement that the relatively large 2014 acquisition of Sterling was made at 5.8 times anticipated EBIT for the year ending 31 December 2015.  We now have the 2015 EBIT number for the company.  Sterling was acquired for $228 million and management’s anticipated 5.8X multiple implies an EBIT for Sterling of $39.4mln.  The remainder of the year’s EBIT amounts to $33.2mln and the remainder of the funds used to acquire centres was $248.7mln, which implies the remaining centres were acquired for 7.5 times EBIT.

This latter finding is in stark contrast to the case studies included in the company’s own 2015 results presentation for small acquisitions for 2010-2013 on 1-year forward multiples of 2.85X to 4.26X.

So the company is paying more for acquisitions, there are fewer being acquired, and those that have been acquired appear to be becoming less profitable.  Meanwhile, corporate overheads appear to have risen materially.  We’ll leave it for you to watch whether these metrics improve in the coming six months or deteriorate further.

Article contributed by Montgomery Investment Management:  (VIEW LINK)