My investment case for GEM, page-10

@Jimmy_C,

Thank you for raising a number of valid and interesting points.

Your comment about the law of diminishing returns is a very important one, and one that I did not give enough emphasis to in my original post. Fortunately, GEM do provide Like-for-like EBIT statistics (albeit in a format that is not always consistent) in their annual investor presentations, so it is not too difficult to reconstruct the EBIT growth path on a “same-centres” basis, i.e. stripping out the impact of acquisitions.

Looking at the past five years, it looks as follows:

“Same centres” YoY EBIT growth

FY2012: +10.30%
FY2013: +20.73%
FY2014: +9.12%
FY2015: +10.79%
FY2016: +6.45% [*]

[*]: adjusted for the impact of the LDC funding discontinuation; the pre-adjustment figure is +0.76%

Therefore, even on a Like-for-like basis, the trend in underlying EBIT growth is both positive and above CPI growth.

In actual fact, this should not come as a surprise; and that is precisely because (as you correctly pointed out) it is per-capita childcare fees, not just revenues, that have been increasing at an above-inflation rate for the past few years, whereas costs (wages and rents, essentially) have increased at a lower rate.

Which leads me back to your first point, i.e. whether the improvement in EBITDA margins actually has anything to do with the benefits of scale.

It is difficult to give a conclusive answer to this question, but there are some pieces of information that do point in that direction. For instance, from the most recent Investor Presentation (February 2017), you can see (slide 8) that the Support Office Cost per Licensed Place has decreased from 710$ in 2010 to 403$ in 2016 (a negative CAGR of -9.01%); as explained in the same slide, this has been consequence of Support Office staffing levels increasing at a lower pace than revenues (broadly flat from 2015 to 2016, for instance). This is an example of benefits of scale being achieved.

With regard to the NIBD/EBITDA ratio: absolutely, you are right in that a level of 2x does not imply the capability to repay all Net Debt in exactly two years; it was an unclear statement I made and I should have provided more detail as to what exactly was meant there.
For, according to the projections made in my original post, we have FY2019 NIBD/EBIT (not NIBD/EBITDA) = 1.875; assuming constant DA/EBIT, that implies FY2019 NIBD/EBITDA = 1.75. In a hypothetical scenario of zero Capex, 100% EBITDA/cashflow, EBITDA growth = CPI growth, and debt repayment occurring linearly over time, it then does take just over two years to pay down all Net Debt.

That’s what I had in mind and didn’t explain clearly; anyway, the point I was trying to make was just about the sustainability of GEM’s balance sheet.

Regarding your point about using a FY2019 EBIT forecast: generally speaking, I do sympathise with your scepticism about forward ratios beyond one year; I am only doing it here because there is a pipeline of committed acquisitions that are already fully funded and due for settlement by the end of FY2018, whose full earnings impact will be visible in the FY2019 results. Therefore, we are talking about future earnings on which there is a high degree of certainty/observability (based on a 4xEBIT acquisition price as indicated by the Company and above-zero EBIT growth). Note that the FY2019 EPS level I am implicitly assuming in my FY2019 EV/EBIT and Zero Real Growth IRR calculations is more than 25% lower than the target FY2019 EPS of 40c provided by Management; if I were using that one, then GEM would be currently trading at a forward PE of just over 10x.

To conclude, I have no doubt that the law of diminishing returns will ultimately apply to GEM (and that it won’t be long before acquisitions at 4xEBIT are no longer available); what matters the most to me, for my investment rationale, is that the terminal growth rate remains at or above inflation, and I believe there is a strong structural case for that.

I hope this has addressed your questions; let’s keep talking if you have more, as the points you have raised are all sound and interesting, and this is exactly the kind of constructive feedback I was hoping to receive.

Thanks for that.