In late February, the Australia Securities and Investment Commission (ASIC) finally closed the book on the ABC Learning saga as it ended its probe into the collapse of the failed childcare company. As many would remember, ABC was heavily criticised and was placed into administration in November 2008 at the height of the Global Financial Crisis (GFC). Although the GFC was a contributing factor to the demise of the group, many argue that the problems of ABC stemmed from an unsustainable business model based on cost-cutting, poor quality of service and profits generated at the expense of subsidies supplied by Australian taxpayers.
Many years down the track the industry drivers remain unchanged and the idea of a high growth profit making child care market is still highly competitive. But given the rise and fall of ABC, are industry participants making the same mistakes now?
Let’s start with ABC. At its peak, the group had more than 1,000 centres in Australia and 2,000 spread across other countries of the world. The last official disclosure of financial statements for ABC were for the half year ended 31st of December 2007 (showing profits of $37 million). This would suggest a very healthy company but in statements released 6 months later they revealed losses for the 2008 financial year of $437 million (wiping out any profits that company ever made). As a result, directors and auditors of ABC were accused fraudulent behavior and investigations began. These questionable activities included incorporating payments from developers to subsidise loss making centres into operating revenue and extravagantly valuing intangible assets (which made up of most of ABC’s balance sheet).
The crux of the scandal was the acquisition strategy which included the third largest child care provider in the US and the fifth largest in the UK. This lead to over $3 billion in intangible assets accompanied by $1.8 billion in debt and arguably overvalued the true value of the company (this was dismissed by ASIC).
At the peak of its success many advocates of the childcare industry could not understand how a business model that typically has staffing costs of 80-90% of operating revenues with similar fee structures was generating ‘profits from ordinary activities’ of 30-40%. With this substantial fixed cost base, occupancy rates become key to success in this industry and concerns began to grow when ABC stopped reporting its occupancy levels well before its collapse. Many even argued that ABC’s presence in the market was causing oversupply which would have further driven down occupancy rates.
So what did this mean for credit investors? 1 year before the group fell apart management issued $600 million of ABC Learning Reset Convertible Notes. These quickly plummeted in value and at the end of 2008 it was announced no further interest payments could be made. Retail investors weren’t the only ones effected with the big four banks having a combined exposure on almost $1 billion. Ultimately, ABC stakeholders were misled by management and paid the price.
Eight years on the childcare industry is a much more even playing field. Market participants are expected to generated $10.6 billion in revenue (up 12.2% on the previous year) due to higher fees and strong growth in government funding. However, post ABC’s failure the industry is more fragmented with the top four participants accounting for less than 20% of revenue. Half the market is run by non-for-profit organisations which has resulted a higher focus on quality of childcare rather than investors’ interests (the ABC era).
G8 Education (GEM) is arguably the biggest Australian childcare in the industry and is the only participant to have outstanding debt securities. While GEM has a similar business model to ABC the two childcare providers are vastly different in terms of risk profile. As previously mentioned, due to the high fixed cost nature of the childcare model, participants cannot rely on organic growth to expand. Therefore, it seems like the acquisition route is inevitable. However, what a company decides to pay for its acquisitions is completely controllable by management. With GEM leading the way, four times EBIT has been used across the industry when looking at attractive childcare targets. In comparison, ABC paid 32 times EBIT for their acquisition on the third biggest childcare provider in the US (Learning Care Group) in 2005. This is where the two companies differ immensely. While GEM is able to yield a sizable profit margin on acquisitions, ABC would have struggled to do so and the accompanying falsified records did not help this transparency. This isn’t to say that acquisitive behaviour is not risky but if done correctly the acquirer should be able to generate sustainable growth in the long term and level out any dint in creditworthiness that may have occurred from required debt funding.
The difference in acquisition multiples can have a significant impact on the amount of debt a company has outstanding. This is illustrated by the graph below. At the peak of the ABC’s strategy, the group had $1.5 billion in net debt but only produced a net profit of $143 million (FY06). On the other hand, GEM realised a net debt of $321 million and produced a net profit of $89 million for the 2015 financial year. If we standardise this (Net Profit/Net Debt) ABC produced 9 cents of net profit for every dollar of net debt accumulated while GEM yielded 28 cents of net profit for every dollar of net debt. The results speak for themselves and highlight the importance of negotiating acquisitions rather than blindly bidding to ensure growth rates continue.
What can we learn from this? Debt funded acquisitions are risky in nature and are usually cautioned by credit investors and loved by equity investors. This can result in the issuance of high yielding debt securities which many would consider highly risky. However, with proper analysis investors can discover than these securities may have overstated risk and actually offer very attractive risk-return opportunities.