Is childcare a profitable business for investors? With wages and standards rising, sustainability is becoming a real concern.
Childcare — just like aged care, as Crikey reported on Thursday — is a long-term growth industry. Tick. Childcare is heavily subsidised by the Commonwealth, to the tune of $5 billion this financial year and rising. Tick and a cross, given reliance on ever-increasing public subsidy is problematic and the Productivity Commission has been tasked with finding more efficient ways to deliver services “within current funding parameters”.
Is childcare profitable? Highly questionable. Margins are shrinking as standards go up and wages — which account for roughly two-thirds of the cost of childcare — rise with them. Despite high daily fees being charged there are very real doubts whether childcare can generate sustainable profit growth enough for a big, ASX-listed operator.
Which is why some in the industry look on in amazement at the share price growth that Brisbane-based G8 Education has experienced over the past year — it’s the ninth best performer on the ASX200 in 2013, up 94% to $3.16.
For those in the know, G8 is a frightening mix of a childcare model used by collapsed ABC Learning, run by principals implicated in the collapse of fund manager MFS.
Lawyer and Crikey commentator Adam Schwab’s book Pigs at the Trough has a gripping account of the downfall of both ABC and MFS. To recap: under founder Eddy Groves, ABC grew quickly: in the six years to 2007 it went from operating 43 centres turning over $22 million, to 2238 centres around the world with revenues of nearly $2 billion. With about half of ABC’s Australian revenue funded by taxpayers via the then 30% childcare rebate (now 50%), it looked like a reliable earner, hoovering up subsidies.
ABC’s acquisition spree was funded by a combination of pre-GFC debt, propped up by equity raised against constantly written-up intangible assets, “childcare licenses”. The more ABC paid for childcare centres, the more it booked as goodwill on its balance sheet, creating a perverse incentive to keep buying at inflated prices. But as Schwab recounts, the more ABC grew, the more its profitability and return on equity declined.
By the time the GFC struck in 2007-08, ABC had debts peaking at $1.8 billion and its earnings results were revealed to be smoke and mirrors: profits were inflated by accounting trickery including one-offs like a liquidated damages claim and an acquisition at a discount, so-called service fees paid by childcare centres that had fallen short of a guaranteed occupancy rate. A lot of the genuine income that was being made was funnelled out of the company through related-party deals. As Schwab writes, “if the rise and fall of ABC Learning Centres proved anything, it’s that some businesses are just not made for profit”.
The collapse of ABC cost the Australian taxpayer $108 million, resulted in the closure of hundreds of unprofitable centres, and threw childcare arrangements for 30,000 kids into chaos — a disaster featuring, it must be said, a string of Coalition luminaries from Michael Kroger to Larry Anthony to Sally-Anne Atkinson, and cleaned up by the former Labor government (now there was a royal commission gone begging).
Under Labor, new national quality standards were introduced, principally in the area of teaching qualifications and the staff-to-child ratio. The Coalition is looking to streamline those standards — it is part of the brief for the PC, which will issue a draft report in July — which is strongly supported by the likes of Goodstart, the non-profit operator which is the country’s largest and which took over some 648 of the former ABC centres.
At first Goodstart, succeeding where ABC failed, might seem to demonstrate that childcare can be made to work at scale and pay. But Goodstart is a very low-margin operator. On 2012-13 revenues of $679 million, 46% of which came from Commonwealth funding, Goodstart reported costs of $671 million — leaving just $8 million of profit, or a tiny 1% margin. For a business that employs more than 15,000 people, there is none of the management largesse that listed companies like to spread around: the wages of the top seven executives were just $2.4 million combined. There are no fortunes being made here.
“High occupancy rates are required and ABC’s failure indicates that running multiple centres is no solution, as this business model does not limit costs. The industry as a whole is barely profitable, primarily due to the presence of not-for-profit community-based centres and a lack of economies of scale.”
IBISWorld expects overall industry profit to remain below 5% through 2018-19. While G8 was reporting margins of 16% in 2012-13, the authors questioned how sustainable this would be:
“It remains to be seen whether G8 Education, a publicly listed ASX company, can continue its current aggressive acquisition strategy or whether it will suffer a similar fate to ABC Learning.”
IBISWorld also wrote that rising childcare wages was placing downward pressure on industry profitability. It estimated the average childcare industry wage will increase from $35,116 in 2013-14 to $40,000 in 2018-19, placing added pressure on operators. In that context, the industry has is a lot riding on an equal pay case initiated by unions for childcare workers last year, claiming an extra $10 an hour — a claim that could increase the sector’s wages bill by $1.6 billion in 2015-16
“The model encourages rising costs. It does nothing to limit the growth of high-fee services that are subsidised by taxpayers.”
Unions argue the work of carers is undervalued and that the undervaluation is gender-based because childcare is considered “women’s work”; a research paper by the Fair Work Commission’s pay equity unit shows 97% of almost 70,000 employed in the long daycare sector are female. The government opposes the application, arguing it’s for comparative wage justice not equal pay and beyond the Commision’s purview.
In an excellent piece by Colin Kruger in The Sydney Morning Herald, G8 insisted it had learned the lessons of the ABC Learning collapse: it was not overpaying for centres, imposing a strict limit of four times earnings on any acquisitions, was keeping debt down, and would concentrate on the top end of the market. Only weeks later, however, G8 was out breaking its own rules, paying $228 million — or almost six times earnings — for unlisted rival Sterling Education, which operates 91 childcare centres and had pulled a $200 million attempted float a week earlier. G8 raised $100 million from institutions to fund that acquisition — which will lift its total number of centres to 388 — and a related share purchase plan for retail investors closes next week.
It would all be more confidence-inspiring if the track record of G8 chair Jenny Hutson and Singapore-based former trucker and managing director Chris Scott was not blotted in the fallout from the collapse of MFS, which liked to describe itself as a mini Babcock and Brown or Allco. In a double act, Hutson and Scott were previously chair and MD of travel and holiday management letting rights agent S8, which was merged with MFS in a friendly $1.6 billion deal in late 2006, which was mainly scrip. Barely 14 months later, in January 2008, MFS became one of the earliest casualties of the GFC, going into a trading halt from which it never emerged.
Hutson and Scott declared themselves victims of the MFS collapse, working to oust chairman and former Liberal leader Andrew Peacock. MFS soon went into administration and investors ultimately recovered less than 4c in the dollar.
Hutson’s own outfit Wellington Capital took control of the collapsed company’s largest fund, the frozen Premium Income Fund, presenting herself as a white knight to investors who had tipped almost a billion dollars into what was supposed to be a relatively conservative mortgage fund but had been treated — as liquidators’ examinations would later reveal — like a slush fund by MFS.
Instead of recovering wealth for stricken investors, Hutson’s management of the Premium Income Fund became a sorry circus, with a steady drumbeat of crushing asset revaluations and minimal distributions to trapped unit holders, all while millions of dollars of management fees flowed to Wellington. The PIF is now listed on the Newcastle-based National Stock Exchange and trades sporadically for under a cent. Wellington has stared down a challenge to its management rights by frustrated investors — at one meeting, hundreds of paid extras turned up to a unit holder meeting to vote in Wellington’s favour — and been taken to court by corporate regulators over a restructuring proposal (the case finally goes to the High Court in May).
Suffice to say, the S8 story didn’t end well either. Merged into MFS travel and hospitality business Stella, it was sold to merchant bank UBS and private equity giant CVC Asia Pacific in 2008 in a debt-for-equity deal done under duress, which led to a bitter dispute that its earnings had been overstated. UBS and CVC lost hundreds of millions of dollars on Stella and, now advised by Macquarie, are still trying to offload parts of the business six years later. A trade sale of the hotel accomodation side of the business, rebadged Mantra, failed last year and in March a $400 million public float — one of the biggest of the year — was pulled after the market baulked at the asking price.
Childcare expert Professor Deb Brennan of the University of NSW Social Policy Research Centre (she’s made a submission to the PC) says the reemergence of listed, for-profit groups like G8 is a “real cause for concern from a public policy point of view” and there is little evidence anywhere in the world that it is a model that delivers high-quality service to children. Instead, it delivers an expensive, two-tier system, with for-profit centres competing to charge fees of up to $170/day in the most lucrative markets, while kids in poorer areas scramble to get access to services.
“The model encourages rising costs,” Brennan told Crikey. “It does nothing to limit the growth of high-fee services that are subsidised by taxpayers. Subsidising verifiable reasonable costs rather than fees charged would be an improvement. We need to be prudent about use of taxpayer funds.”