The childcare sector is a 12 billion dollar industry which plays a vital role in the Australian economy. Childcare centres not only enable parents to return to work, but are large employers themselves and are trusted with nurturing children through their formative years.
In this podcast, we look at the industry in detail including the demand, the challenges, the businesses and what the future holds for the sector.
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Transcript
Sean Aylmer
Welcome to Behind Business, the podcast where KordaMentha experts discuss the most pressing issues facing business today. I'm Sean Aylmer, an economist and journalist for 25 years, and the host of the Fear and Greed Daily podcast.
The childcare industry in Australia is both huge and hugely important to the economy. The sector plays a vital role in enabling parents to participate in employment and childcare centers are trusted with nurturing children through their formative years. Childcare centers don't just allow others to return to work fueling the economy. They're also businesses themselves. Government subsidies form a key component of revenue for most centers around Australia, but the whole sector has been hit by COVID-19, as more people worked from home and parents withdrew their children. Today, we'll look in detail at the childcare industry; the demand, the challenges, the businesses, and what the future holds for the sector.
I'm joined by two experts from KordaMentha. Bill Sykes is an executive director from the real estate team and joining me from Brisbane and Ryan Rabbitt is a partner in restructuring based in Sydney. Bill, Ryan. Welcome.
Bill Sykes
Thank you, Sean.
Ryan Rabbitt
Thanks Sean.
Sean Aylmer
Firstly, to you, Ryan, can you provide us with an understanding of how big the sector is? What's the childcare sector worth in terms of revenue and how it's performed?
Ryan Rabbitt
Thanks, Sean. So the childcare sector generated total revenue of about 11 and a half billion dollars in FY 2020. And that represented a 10% decline relative to FY 2019 and the year was impacted by some of the toughest months in the COVID-19 pandemic across Australia. Over the five years to FY 2019, however, the sector grew at around 2.3% per annum to total revenue of 12 and a half billion dollars. And that period was largely driven by some solid industry fundamentals, including government support via the childcare subsidy program, growing female workforce participation and also population growth. However, that was partially offset by some challenges in the sector around excess capacity in certain markets.
Sean Aylmer
Okay. So are there different types of childcare? I think of childcare in the way that: my children went to childcare, but what's the composition of the market. And I'm interested in who owns all these child centers, whether it is private equity, whether it's not-for-profit, that type of thing.
Ryan Rabbitt
Yeah. So Sean, the childcare market provides care for children 12 years and under, and there are broadly three categories of childcare. There's long daycare, which is for children aged between zero and four years of age. This represents roughly 64% of the market there's outside of school hours care or before and after school care, as it's known and that's for primary school aged children between five and 12 years, and that represents about 35% of the market. And then there are a range of other types of care, predominantly family daycare, which takes place in the educator's home. And that care makes up the remainder of the market. As you suggest, the ownership of the sector is in fact very fragmented. There are a lot of small participants in the market, the largest two operators account for about 20% of market revenue. And actually over half of total providers are in fact not-for-profit organizations. So, that market fragmentation is a key reason why we've seen such a growth in private equity presence over the last five years.
Sean Aylmer
Okay. So, the two largest one is G8, I believe, which is listed. And the other is Goodstart, which is not-for-profit. Is that right?
Ryan Rabbitt
Yeah. That's that's correct.
Sean Aylmer
Bill, I might bring you in at this point. Ryan mentioned some of the reasons why there's demand for childcare centers from your point of view, is it a demographic issue primarily, or is it a return to workforce issue primarily? How's it work?
Bill Sykes
Well, look, it's both of those things, Sean and as Ryan touched on earlier, one of the traditional drivers is workforce participation. So demand for workforce participation and in particular female workforce participation or maternal workforce participation. And it's important to note that increased workforce participation typically improves national economic productivity and higher national productivity is always a policy goal of both sides of politics. So, in turn, another key driver of demand is government support and subsidies to the sector, which has been simplified recently to an all encompassing childcare subsidy, which is means tested. But as you've mentioned, the other key demand driver is population growth and population growth in that key demographic cohort of young families.
Sean Aylmer
So Bill, parking the coronavirus pandemic, because that was a very different year, 2020, and this will probably be the same, both those factors that you're talking about, suggest there will be growth in the market over the next decade or two.
Bill Sykes
Yes, that's right. That's fair to say. And there has been growth in the market. There has been growth in workforce participation and I think that's an upward trend that is going to continue Sean.
Sean Aylmer
So Ryan, can you explain the government subsidies in the sector?
Ryan Rabbitt
Government support for childcare sector comes via the childcare subsidy or the CCS as it's known. That program was introduced around 2018 and it's paid directly to the childcare operator. The government did announce in FYI 2021 budget that it estimates CCS funding of around $9 billion to the childcare sector. So it's clearly very significant. I mean, to put that into some context, as I mentioned, the sector revenue in FY 2020 was 11 and a half billion dollars. So it's a fundamental driver for the sector's financial performance and the demand of parents. The CCS gets a lot of attention, both in politics and also in the media. And interestingly Labor in its response to the federal government's budget did propose changes to the CCS to increase the level of funding. So this is clearly an area to watch for both childcare operators as well as their investors and their lenders.
Sean Aylmer
Okay, so what happened early last year when COVID 19 hit, Ryan?
Ryan Rabbitt
Sean, at the onset of the COVID pandemic in around March of last year, childcare operators experienced a significant reduction in occupancy as parents kept their kids at home, given health concerns around the virus and also because of financial concerns and this had a huge impact on the viability of the sector and many centers were forced to close during that time. Now the government responded fairly rapidly recognizing the crisis faced by the sector. And in April 2020, the government introduced what has become known as free childcare. And this effectively involved the government funding around 50% of an operator's revenue without any financial contribution required from parents. And at that time operators were also able to access the Job Keeper program. Now that program proved critical to providing cash to the sector, to pay wages and rent and ultimately enabled to continue operating and provide a critical service for the functioning of the economy. Since that time, there have been a series of transition packages provided to the sector by the government and those packages concluded at the end of January this year.
Sean Aylmer
So Bill, how tough is it maintaining occupancy at the moment? Now I'm only going on G8 numbers because they're released publicly because it's a listed company and they were at about 75%, late last year. And they've said it's creeped up since then, but that doesn't seem super high in terms of occupancy rates.
Bill Sykes
Yeah. Sean G8 is a pretty good proxy for the market because it does have such a broad spread of childcare center locations. But look, generally the challenge of maintaining occupancy varies from center to center, but one of the key factors affecting occupancy and includes location of the center and the sub-market supply, meaning how many other competing centers are there within a short drive time of the subject because childcare supply's lumpy, in nature, meaning that the demand supply equilibrium in a suburban sub-market can be thrown out by the addition of just one new center, for example, the additional supply of a hundred new childcare places into a suburb may mean the difference between profitability and loss-making for an existing center in that suburb. We've actually seen an example whereby we were appointed to work through the restructuring of a portfolio of childcare centers that had common ownership and management.
It was interesting that upon our appointment that the occupancy in one of the centers was just 10%, whereas another of the centers located about 15 minutes drive away was a hundred percent. And the main reason for this was that the under-performer was located in the suburb that had experienced major overbuilding of childcare centers previously, whereas the overperformer enjoyed a low supply sub-market in the location of very expensive land, which meant there were high barriers to entry for competitors. So this is a key issue to look out for; is there many development applications for new centers either approved by council, or in a council for approval. And if those centers get developed and delivered, then that will add to supply. And so aside from location and supply, the other key drivers to build occupancy and to maintain occupancy is the presentation of the center, the resourcing of the center and the quality of the staff.
Sean Aylmer
So Bill, How are childcare centers considered, as an asset class?
Bill Sykes
Look, generally childcare is seen as a seen as a relatively safe and secure asset class, given the government support to the industry and the typically long leases in place, almost like a social infrastructure asset. Childcare centers often make the property industry headlines in terms of high valuations and record low yields. This is usually now the well located centers in locations with high barriers to entry and long leases in place to ASX listed operators. So it's really investors buying the security of those rental cash flows. So passive investors, it is important to note though that not all childcare centers exhibit those strong lease covenants and the yield achieved at one property auction won't necessarily mean that another center in the same area, should trade on a similar yield. Property evaluations and their yields should be determined by range of factors, including the sustainability of the operating tenant, to be able to continue paying rent. And this will in turn depend on how well they're maintaining the presentation of their center, how well they're training their staff and how well their managers are controlling wage costs. Therefore real estate backed by a single operator tenant who isn't keeping up with the industry expectations in terms of service delivery and quality of staff should trade at a discount to real estate backed by a quality operator with an ASX listed parent company guarantee on the lease.
Sean Aylmer
Ryan, I might bring you in on this in terms of valuations of childcare centers. What are evaluations like in the sector?
Ryan Rabbitt
So the ASX listed long daycare businesses currently trade an average enterprise value to EBITDA multiple of roughly six and a half times. Interestingly, Think Childcare is currently subject to competitive takeover proposals and the valuation multiple implied by the latest takeover proposal is around about that six and a half times, so that's very instructive. The sector has experienced multiple contraction over recent years and around 2018, the sector was trading on the ASX at about 10 times EBITDA. And that declined to around eight times EBITDA prior to the onset of the COVID-19 pandemic in 2019, that likely reflects excess capacity in certain markets, as well as some of the operational challenges that were experienced by some of the players. Separately, select portfolios of long daycare centers have privately traded at around about four, four and a half times EBITDA during that time.
Sean Aylmer
It seems that, I'm going to say 15 years ago, with ABC Learning, it was such a boom sector. And then that didn't work out. And it took a while to filter its way through the system. Then again, it seemed to be growing again, but it's interesting just in the last couple of years, even COVID aside, it wasn't going in the right direction.
Ryan Rabbitt
Yeah, look, that's right. The returns, Sean in childcare have historically been fairly high. And if you look at those ASX listed operators, their return on invested capital has historically been around 14% and that reflects high levels of profitability and also high levels of occupancy. Clearly those sorts of returns will attract, attract, sorry, more players to the market. That's part of the reason why we've seen private equity come into childcare in a big way, second to roll up players, given the fragmentation in the market.
Sean Aylmer
So Ryan, how has the sector bounced back in 2021?
Ryan Rabbitt
The childcare sector recovery, since the peak of COVID 19 and 2020, certainly appears broad-based from our perspective, this is reflected in conversations that we've had with various operators. It's certainly reflected in the recent ASX results reporting that's occurred. We also see that in a department of education skills and training operator survey that was released in November of last year.
Now this recovery really is on the back of a couple of things. It is Australia's fantastic record in managing COVID-19. The level of new infections is remained low. And as a result of that, we've seen limited restrictions on movement. So parents are free to go to work and put their kids in childcare. And then secondly, the Australian economy has experienced a pretty solid rebound from the depths of COVID the contraction in GDP in the first half of 2020 was substantially recovered in the second half of 2020. And also the rate of unemployment has bounced down from a peak of around seven and a half percent in July 2020, all the way down to 5.8% in February of this year. So, clearly again, economy's performing well, people are working and they're sending their kids to daycare. So market conditions generally appear to be a lot stronger than, certainly we thought they might be nine, 10 months ago.
Ryan Rabbitt
Yeah, that being said it is worth noting that there were some interesting data points coming out of the recent ASX reporting, which suggests that this recovery might be a little bit uneven between operators. Some of the ASX listed businesses suggested that whilst the 2020 occupancy rebound was pretty solid, performance through to say February of this year, in some instances was below the occupancy performance in February of last year, which is interesting. And that said, some other operators are suggesting that they're performing better in February of this year than they were last year. So it's going to be really interesting to see how the performance of those operators evolves over the remainder of the year. But I think, stepping back from all of that more broadly, as we've suggested, we're seeing really strong medium-term tail winds in the sector, but the near-term ongoing recovery, certainly isn't without risk.
Firstly, we've seen some pretty significant changes in working habits through the crisis. Parents are staying home and that calls into question, whether or not, in a more challenging economic environment, they're going to spend the money to send their kids to daycare. Now we probably don't see that impact as great in long daycare. So young kids age, zero to four, clearly it's tougher to work from home for a day and have your young kids around you. But certainly we see that playing out in the outside of school hours care part of the sector where kids might be eight, nine years old. They finished up school at three and they get home by four. And then as a parent, you're spending an hour, an hour and a half finishing off your working day, whilst your kids maybe are at home doing their homework or watching TV.
So that's certainly an interesting dynamic separately, the COVID 19 vaccines, obviously being rolled out in Australia now. That's going to take some time. So there's remaining risk that we say localized outbreaks again, that restrict movement and force parents to keep their kids at home. The economic rebound has been strong. However, Job Keeper is rolling off at the end of March 2021. And so it'll be interesting to see what implications that has for unemployment and the economy more broadly. And then separately, there's been a material level of government support for the sector specifically through the crisis or the COVID-19 crisis. And that support ended in January of this year. And it'll be interesting to see how operators perform when they're effectively weaned off. , what's been a bit of a sugar hit.
Bill Sykes
Where do you see child care occupancy rates in the next five years, let's say? Because if you're investing in it, you're not investing it for six months time. You're investing for five years time.
Ryan Rabbitt
Sean, we certainly see that there are strong medium-term drivers within childcare that will support occupancy and profitability. Bill will talk through a number of those; female participation in the workforce, population growth. Those things have returned since the depths of the COVID-19 pandemic and will continue to support the sector over the longterm. So, so it's certainly attractive for investors.
Bill Sykes
I agree with that, but then, against that, the operational challenges to persist as you have high fixed costs of rent and wages, and wage costs and the ability to control your wages is always a key operational challenge for centers. So, good well-trained staff, a key to building and maintaining occupancy. However, well-trained staff come at a cost and the National Quality Framework, another regulation in Australia, sets out a requirement for continuing education of staff. As the staff become more qualified, they typically become more expensive under the relevant award. So this in turn becomes a cost challenge for operators. So the ability of an operator to, to manage wage costs effectively will always impact the bottom line. And the better center managers will always be proactively managing staffing levels within the required child to staff ratio is in order to not overspend on wages. This includes, at a granular level, active management throughout the day. That some children are collected and rooms are consolidated, and staff can be allocated more efficiently within the regulations. So I agree with Ryan that there is an upward on occupancy, But the operational challenges will persist.
Sean Aylmer
So there's so much going on in the sector, Ryan, if you're in that sector and you are childcare operator, who's perhaps grappling with some of these challenges right now, what should they be doing?
Ryan Rabbitt
Yeah, Sean. So when we think about what childcare sector operators, or investors and their lenders, should be thinking about now, if they're dealing with occupancy challenges. We start at firstly, a critical assessment of the center portfolio. People should really be focusing on those underperforming centers and the levers that are available to them to improve performance. Questions should be asked, like, how do I optimize my rostering to reflect a low occupancy environment? Can I engage with my landlord for the concessions, for example? If elements of the portfolio aren't performing and there's not a desire to pursue a long-term turnaround, then certainly options for divestment can be explored. We're seeing an increase in childcare, M&A activity as the sector outlook begins to improve. And the investors in the sector are certainly looking to put money to work. Operators might also want to think about improving the quality of services that they're providing in order to attract new enrollments, certainly improving the National Quality Framework rating.
Ryan Rabbitt
And, in general, experience is very supportive of increasing rostering and adding additional services like language classes, for example, is very attractive to, to parents. Another example that we noticed in the Think Childcare reporting was that they drastically increased their marketing via letterbox drops during the free childcare period. And they got quite a significant bump in occupancy that was retained when parents started to pay for childcare again. So those are some ideas that operators can think about. Focusing on cash flow, is obviously always critically important. Cash is King. And if you're facing occupancy challenges, then certainly understanding where your cash is coming from and where it's going is critical to giving you the runway to implement a turnaround. And then finally, and this one is really important: proactively engage with all your stakeholders. Generally your lenders are going to be supportive and they're going to want to talk to you early on if you facing issues and often, and if you do that, then generally you're going to get the outcome that you're after.
Sean Aylmer
Presumably that advice goes from the very large guys right down to the single operator players.
Ryan Rabbitt
Yeah, look, it absolutely does Sean. The issues that we're seeing in the market at the moment apply to some of the big operators and it also applies to some of the smaller operators as well.
Sean Aylmer
Now you think about childcare professionally, Ryan, Bill, have you used childcare centers? Do you have kids that have gone to childcare centers? Do you think about it differently? Do you walk in and look at it and think, Oh, I'm not sure about the staff-to-child ratio and that sort of thing. Or can you just enjoy the childcare center?
Bill Sykes
Sean, I'm actually particularly critical. My children are a bit older now, and I no longer am a customer of childcare services, but I am pretty critical because prior to joining KordaMentha I actually ran a reasonably large childcare business. We had about 20 operating centers with approximately 500 staff, so a reasonably big business. And so I was one of those parents who used to walk in and speak to the center manager and let them know that the lights were still on out the front. And that there were a few weeds in the garden on the way down. So I don't know how much the staff actually appreciated that.
Sean Aylmer
We other parents really appreciate it because I was too scared to talk this staff, but we need to do that. So you're on our side.
Ryan, Bill, thank you very much for talking to Behind Business.
Bill Sykes
Thanks very much.
Ryan Rabbitt
Thanks Sean.
Sean Aylmer
I've been talking to Bill Sykes, executive director from the real estate team at KordaMentha and Ryan Rabbitt partner in restructuring. Well, there it is. Childcare's a $12 billion industry, not only important as a business itself, but as a conduit to other parts of the economy. It's recovering from a particularly tough period during the coronavirus crisis without government support packages, many would have failed last year. But finally occupancy rates are slowly creeping up. There are broader tailwinds for the sector to namely greater participation in the workforce, particularly by women, and population growth. But it's a tough business. Having quality staff is critical as is being in the right location without too many competitors nearby and not surprisingly given they care for children, how they look and feel matters.
Sean Aylmer:
Thanks for listening to Behind Business, the podcast where KordaMentha experts discuss the most pressing issues facing business today. I'm Sean Aylmer.
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