Lex Hall: Hi, I'm Lex Hall for Morningstar. Today, I'm joined by Morningstar equity analyst, Gareth James. He's just produced a report on the childcare sector and we're going to talk about the outlook for the sector and indeed talk about a few names that Gareth considers to be undervalued.

G’day, Gareth.

Gareth James: Hi, Lex.

Hall: Is it fair, Gareth, for investors to see childcare as one of those essential services for which there always be demand, do you think?

James: Yeah, absolutely. For a long time now, childcare has been considered really crucial component of the economy that enables parents to go out to work and in particular mothers to participate in the workforce. That's considered to be a very important part of the economy and we think if anything that view is just getting stronger and stronger.

Hall: And I suppose in Australia childcare is sort of synonymous with in the past 10 or 15 years or so ABC Learning and Eddy Groves. I mean, he famously I think said that childcare was a universal service, but ABC Learning had its problems, didn't it?

James: Yeah, that's right. So, I mean, the childcare sector in Australia has always been highly fragmented. In the early 2000s, ABC Learning tried to consolidate the sector off the back of various changes to government funding for the sector. But since then there's been quite a few changes in the sector. So, it's a lot more regulated now and we think generally speaking the operators and the landlords are much more reputable than ABC Learning was.

Hall: OK. And one of the key drivers you mentioned in your report is subsidies. Tell us what sort of effect subsidies have had on the industry and will continue to have, you think?

James: Yeah. So, this sector is really completely dependent on government subsidies. So, government subsidies comprise about 60 per cent of the sector's revenue. So, if subsidies were to stop overnight, the sector would completely collapse. So, what we've seen during the recent crisis is that the sector has been faced with collapse and the government stepped in and it said, well, no, we basically fund the whole sector anyway. So, we're going to keep funding it through this crisis. And that's really the gist of the report that we've published that we think that whatever happens during this crisis, the sector isn't going to collapse because the government is always going to want it to keep operating because it just is so important to the economy.

Hall: All right. There are three names we should talk about. The first is the childcare operator and the other two are landlords. Let's look at the childcare operator first. That's G8 Education, the stock code is GEM. What do you make of its outlook?

James: Yeah. So, obviously, in the childcare sector, you have the operators and then you have the landlords. The landlords own the buildings; the operators operate childcare centers from within the buildings. The operators are a much more risky investment proposition because their profits are far more vulnerable to changes in occupancy rates within the childcare center. The landlords get paid pretty much irrespective of what happens to occupancy rates. Landlords would only really lose out if operators went bankrupt. So, looking at G8 Education, they are going to be impacted this year by the pandemic. They've raised capital to shore up their balance sheets. We think that the government is going to continue to support the operators. So, we don't think G8 Education is going to go bankrupt as a result. We don't really know what's going to happen in the next few weeks with things like Victoria. But what we do think is that the government is just going to keep on stepping in and supporting the childcare sector.

Our general view is that the pandemic is going to ease from next year and things will start to return to normal and then we think G8 is going to be back to kind of normal situation in a couple of years' time.

Hall: OK. Let's move on to those landlords which you'd mentioned. The first one is Charter Hall Social Infrastructure. That's at a 31 per cent discount. Can you give us an idea of their scope as a player?

James: Yeah, sure. So, Charter Hall Social Infrastructure Trust and Arena REIT, they are both real estate investment trusts. They both own a few hundred childcare centers throughout Australia. In both cases, they have kind of diversified into more what they are calling social infrastructure. So, it's really kind of any buildings which house organizations which are funded by the government or some kind of social infrastructure type things. So, it could be something like a bus terminal. Arena has bought some facilities which house people with disabilities which receive funding from the government. So, they've kind of got this approach where they are very kind of low risk real estate assets because they are kind of there for the very long term and they are funded by the government. So, childcare fits that bill.

So, when we saw the pandemic first occur in Australia, Charter Hall Social Infrastructure Trust and Arena REIT experienced sharp share price falls because people were concerned that the whole sector was going to experience bankruptcies and that they'd have lots of empty childcare centers. But we took the view the whole way through that that just wouldn't happen. And they have rebounded to a large degree, but we think there is still further potential there, particularly with the interest rate environment. So, we've got interest rates close to zero in many parts of the world and probably unlikely to increase much for quite a while. So, if you can get defensive yield assets, they are very appealing.