Description

I recommend shorting Bright Horizons.   In summary, this is a low quality business, trading at a high price, facing overhang from selling by a majority owner - a private equity firm.

This short idea was inspired by Wesley Gray’s “Quantitative Value” book.  Similar to Greenblatt’s Magic Formula, Gray uses a two factor ranking system, valuation and business quality, to find ingredients for portfolios that outperform the market.  His research confirms TEV/EBIT as the best valuation metric but in contrast to Greenblatt his research finds that gross profit margin is a better indicator of business quality than ROC.   By Gray’s measure, Bright Horizons is the exact opposite of the kind of business you want in your portfolio.  It is an expensive, low quality business with a fantastic story.  In addition, the private equity firm that controls Bright Horizons, Bain Capital, is selling.  Bain has been involved in the business since the 1980’s and probably knows the business better than anyone.  I recommend you jump ahead of Bain in the selling.   They’ve been steadily selling shares since the IPO in 2013.  Since Bain took the company private they have tripled their money (sales increased by only 60% in that same time period).    The stock is trading at an all time high.

Why would someone take the other side of the trade?  This stock has a lot going for it – especially in the momentum department.   The share price has appreciated by 40% in the last year, 17% ytd and 100% since IPO in January, 2013.   Management will be actively touting the stock in roadshows.   There are numerous demographic trends, social studies and education concepts that support the childcare business and their premium valuation – ask Obama!  Frankly, if you’re a parent in a big city like Boston – childcare feels like a tight market.  This investment feels like a great way to invest in that tightness.  The childcare industry has demonstrated strong pricing power for the last decade.  The numerical justification for Bright Horizon’s valuation is based on historical growth – which has come partly from acquisition.   Going forward, the high valuation implies continued price increases (3-4% per year) and continued accretive acquisitions. 

I believe that using Gray’s approach to business quality, gross profit margin, is appropriate for Bright Horizons since this is not a business with any sustainable competitive advantage.  The main components of COGS are labor and rent which are real cash costs needed to support current business (thus it is fundamentally a relevant measure).   The valuation metric of TEV/EBIT understates true leverage as they make use of ~700 million in operating leases.  If you include the operating leases as debt their TEV/EBIT goes from 26x to 31x - expensive any way you look at it.

It is useful to think about Porter’s 5 forces to discuss the competitive landscape of the childcare industry.  What will the future look like for childcare? 

Threats of substitutes – Bright Horizons is an expensive childcare alternative to Churches and the YMCA.  Expensive private childcare has filled the gap between these social organizations and your own personal nanny.  In a middle class area where you are paying $15k/year for childcare a nanny becomes a good alternative especially if you have more than one child.  Bright Horizons depends on there being this middle area between Church/YMCA and a private nanny for continued growth.  Dad is another substitute.  It is becoming more common for dads to stay home with children.  Male maternity leave is growing in acceptance.  It wouldn’t take much for companies to offer their own childcare programs without help from Bright Horizons.  I won’t mention robo-care but if Google is going to make self-driving cars…

Threat of new entrants – Traditionally, childcare has not required large capital expenditures.  You can start a childcare business in your house.  The government will loan you money to do it.  Here is an illustrated WikiHow site that shows step-by-step instructions on how to open a childcare business:  http://www.wikihow.com/Open-a-Child-Care-Business.   The biggest threat of new entrants may be from the government with a “universal childcare” tax credit.   I’m not sure where Bright Horizons will fit in as they currently do not accept many of the existing welfare related credits offered on a state-by-state basis.  Lastly, there’s always the Uberfication of daycare as a threat.   Imagine having an ipad app that finds the nearest daycare slot, babysitter or at-home provider.

Bargaining power of suppliers – suppliers being the labor they hire.  Traditionally, child care centers have faced high turnover rates.  As minimum wage rises they will face more issues in this area.   Labor doesn’t add enough value to justify premiums for experience or extra training.  Lower nationwide unemployment has been driving their topline but could hit their expenses over time.  This is a very labor intensive business.  1 teacher per 4 infants is required.  This ratio will stay the same in the future. 

Bargaining power of customers – Right now customer bargaining power is low because unemployment is trending down.  People are going back to work.   A mother’s maternity leave ends and her child has to go somewhere – so the market feels tight.  This trend cannot persist because unemployment rates cannot go much lower than where they are now.   Mothers are hard to please when it comes to daycare.

Rivalry amongst competition – For acquisition, management says there is little competition  – there is so much private equity money on the sidelines willing to do deals at lower and lower returns that I don’t see how this low competition for good businesses can persist.

Other Rivalry – Bright Horizon’s closest competitor on a larger scale would be with Kinder Care (parent: Knowledge Universe).   Knowledge Universe is a private company with which junk-bond kind Michael Milken is involved.  It has more revenue than Bright Horizon and appears to have a similar mission.   Rivalry could change for the worse if Knowledge Universe went public.  I imagine the Milkens are watching Bright Horizon’s valuation.  They spun off Leap Frog at an opportune time in 2002.

Other value propositions touted by BFAM that aren’t really value propositions:

Last year BFAM authorized a $225 million share buyback.  However the buyback is not directly impacting supply & demand of the shares because it is not reducing the float.    The company bought shares back directly from Bain, not from the market.  Despite the size of the buyback, there still the same number of shares outstanding as the date of the IPO (due to option creep) and the free float has effectively remained the same.

Bright Horizons touts the fact that they’re being used by many big, Fortune 500 clients.  This all sounds very prestigious and nice but the profit margins still reveal this is not a great business.  These fortune 500 companies that are using Bright Horizons are not complete dummies when allocating capital and choosing suppliers … they’d likely hire their own daycare personnel and pay them directly if it made sense.

In the big cities like Boston and New York, where all the analysts live, there may indeed be a shortage of yuppie daycare.  In my little town (North San Diego), the Bright Horizons center has no waiting list.  I recommend you join Bain in selling some Bright Horizons shares – the borrow is cheap, the price is high and the business ain’t no Google despite the Google logo being prominently displayed on their client list.

Catalyst

overhang by PE firm selling

valuation