Not So Bright Horizons

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Business Description

Headquarters Watertown, MA Founded 1986 Employees 25,400 Company: Bright Horizons Family Solutions Inc. (NYSE: BFAM), public since January 2013, is the   first publicly traded company which provides employer-backed child care service. The company enters multiyear contracts with employers who offer child care as part of their employee benefits packages. Bright Horizons operates and manages both standalone centers as well as employer in-house care facilities. The company has 922 centers in 41 states as well as the United Kingdom, the Netherlands, Ireland, Canada, and India. They care for approximately 85,000 children worldwide.
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Original Investment Rationale

• Public Capital for Employer-Backed Daycare: Bright Horizons has access to the public capital market that no other employer daycare center does. Rising operation costs due to tighter restrictions and increasing caretaker wages has put financial pressure on many daycare facilities. Bright Horizons has the funding to meet these growing expenses as well as expand their business.

• Sustainable Niche Market: Bright Horizons operates in a niche market of the daycare industry. The company targets employers who want to provide child care as part of its benefits package to employees. Employer based child care services are proven to cut employee turnover by 40-60% and improve recruitment by up to 80%. Any employer who offers this benefit has a distinct hiring and retention advantage. Bright Horizons is the leading provider for employers looking to gain this advantage. The company is the largest player in this market, owning a market share 5 times the size of its closest competitor. Bright Horizons has contracts with 900 employers, including 130 of the Fortune 500 companies. These include Sony, Starbucks, and Pfizer. They agree on multi-year contracts with those employers that span 3-10 years.

• Acquisition Potential: Not only will Bright Horizons look to grow organically, but they have the opportunity to expand rapidly through acquisition. The daycare industry is highly fragmented and Bright Horizons has a proven history of acquiring smaller centers in the segmented market. Since 2006, the company has completed the acquisition of 242 child care centers. In the first two quarters this year, they have already acquired 32 new centers, and anticipate the addition of 25 new centers through acquisition for the remainder of 2015. Since their IPO 2013, the company has already acquired two of major competitors.
Recent Performance

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Our investment in Bright Horizons has returned about 1% within the last year period beginning January 2016 to January of this year. Likewise, the S&P has returned close to 20% and the industry around 17% for the same period. The following events affected the stock’s performance of this time period.

New Staff PositionStephen Kramer PresidentMandy Berman Chief Admin. Officer Sandy Wells Chief Develop. OfficerA. Stock Price Falls due to New Staffing: The company names Chief Developing Officer Stephen Kramer the new President of the company, which became effective in January 1st. Two additional long- tenured Bright Horizons leaders were also promoted to expand executive leadership roles effective January 1. Mandy Berman, who joined Bright Horizons in 2005, was promoted to the role of Executive Vice President and Chief Administrative Officer, and Sandy Wells, a 23-year veteran of the company, was promoted to Chief Development Officer, leading the company’s sales and client relations teams in the employer market. Both Berman and Wells will be reporting to Stephen Kramer in his role as President. These announcements follow the retirement of President and COO Mary Ann Tocio this past July and have been part of the company’s long-standing commitment to succession planning and developing a deep bench of leaders.B. Instability Due to Pre Financial Release Announcement of 2016 2Q Earnings: Stock went down before the earnings release. But by August 3rd, 2016 the earning releases and the price went back up. Revenue increased $31.6 million, or 9%, in the second quarter of 2016 from the second quarter of 2015 on contributions from new and ramping full-service child care centers, average price increases of 3-4%, and expanded sales of back-up dependent care and educational advisory services.Income from operations was $56.6 million for the second quarter of 2016 compared to $52.1 million in the same 2015 period, an increase of $4.5 million, primarily due to an increase in gross profit, partially offset by increases in selling, general and administrative expenses.  The increase in gross profit and income from operations reflects operating leverage from enrollment gains in mature and ramping centers, contributions from new child care centers, back-up dependent care and educational advisory clients that have been added since the second quarter of 2015, and strong cost management, partially offset by the costs incurred during the ramp-up of certain new lease/consortium centers opened during 2015 and 2016, and ongoing investments in systems and personnel to support the delivery of our services.  Net income was $30.4 million for the second quarter of 2016 compared to net income of $26.9 million in the same 2015 period, an increase of $3.5 million on the expanded income from operations.  Diluted earnings per common share was $0.50 compared to $0.43 in the second quarter of 2015.In the second quarter of 2016, adjusted EBITDA increased $6.1 million, to $80.8 million, from the second quarter of 2015 due primarily to the expanded gross profit.   Adjusted net income increased by $3.8 million, or 12%, to $36.9 million on the expanded income from operations.  Diluted adjusted earnings per common share was $0.61 compared to $0.53 in the second quarter of 2015.In the first quarter of 2016, adjusted EBITDA increased $6.9 million, to $72.4 million, and adjusted income from operations increased $6.0 million, to $48.8 million, from the first quarter of 2015 due primarily to the expanded gross profit.   Adjusted net income increased by $4.0 million, or 14.8%, to $31.1 million on the expanded income from operations.  Diluted adjusted earnings per common share was $0.51 compared to $0.43 in the first quarter of 2015.As of March 31, 2016, the Company operated 936 early care and education centers with the capacity to serve 107,400 children and families. C. Missed 3rd Quarter Earnings: Bright Horizons Company issued their 3rd quarter earnings on Nov.1, 2016. The company stated that its missed earnings expectation was largely the result of higher unexpected for reign exchange headwinds. Bright Horizon expected this decrease in revenue and eps because of a decline in the pound; United Kingdoms’s currency. After Brexit, the pounds value decreased and this impacted the company’s revenue negatively by 3%. In other words, the company increased revenue by 5% but had they experienced the amount of foreign exchange rates expected, the revenue increase would have been 8%. D. Effect of Presidential election – Bright Horizons was one of the few companies expected to be positively affected positively by either candidate in the race. For example, Mr. Trump’s plan tax plans called for more incentives offered to companies to provide their employees with day care services. At the same time, Ms. Clinton stated plans that would expand the child care service based on need. As a result, both candidates presented plans that would have positively impacted Bright Horizons stock.

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Financial Performance
• Third quarter earnings: Bright horizon recognized revenue of $384 million, which is a 5% increase compared to last year and EPS (earnings per share) or $.49. Additionally, the company saw income from operations to be $45 million, which is an increase of 7%. Furthermore, the company had net income of $23 million, which is a 9% increase from the following year. These reported figure are lower than analyst estimates and as a result the stock was punished for it. Analyst expect revenue to be $387 million and EPS to be $.50. The company missed its earnings as a result of foreign exchange headwinds. The company recognized a foreign exchange headwind of 3% which is higher than the expected amount of 1%. This headwind is largely from Brexit because as the pound fell and the dollar rose, the amount revenue the company generated was lower. Likewise, the company may continue to be negatively impacted for foreign exchange headwind.• Margins – In terms of margins, I choose to compare Bright Horizon (BFAM)  to Nord Anglia Education (NORD) , a company builds private schools, K-12. Similar to Bright Horizons, NORD is the only publicly traded company of its kind. NORD has a return on assets of 3.07 % compared to BFAM’s 5.69%. In addition, NORD has a return on equity of 19.75% and BFAM’s is 14.38%. Additionally, BFAM historically has a average gross margin of 76% compared to NORD’s 45%. Lastly, NORD has a historical quarter over quarter growth of 23.9% compared to BFAM at 9.05%. Consequently, NORD is able to grow revenue at a faster rate and earn more from its equity.

• 2017 Outlook – Bright Horizon plans to continue its growth by acquisitions. The company acquired 39 companies within the last quarter and expects for this trend to continue; the company expects to achieve a 2-3% increase in revenue from its acquisitions. In addition to the 39 companies acquired, Bright Horizon also successfully acquired Aquith Day, which is a high – quality child care and early years education serving the needs of families. Aquith Day, which is based in Chesham, operates over 90 nurseries in the United Kingdom (U.K.) Their nurseries are mainly based in London with other locations in Wales, Scotland and England. As a result, Bright Horizon will be able to enter new markets with their merger. The downside of the acquisition is that BFAM will be more exposed to foreign exchange headwinds. Since they increased their holdings in the U.K. coupled with the uncertainty of Brexit, Bright Horizon may continue to recognize higher than expected foreign exchange headwinds. To make matters worse, the U.S. currently has a strong economy. With unemployment below 5%, wages beginning to increase and inflation controlled, conditions are ripe for the Fed to increase interest rates. This will attract more investors to the U.S. because they may be able to earn a higher return compared to their country. This is also bad for BFAM because 46.67% of the company’s debt is long term. Similarly, goodwill represents close to 50% of the company’s total assets, which cannot be turned liquid. As interest rates rise, the company is expected to pay a higher percentage in interest and with the increase in foreign exchange headwinds, this presents an opportunity to miss a payment.
Growth Drivers 

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• Growth through Acquisition – Since 2006, Bright Horizon has acquired more than 300 centers from other daycare operations. These acquisitions cost on average $1.2 million and take about three years to fully mature. Furthermore, Bright Horizons has the capacity to purchase some of these centers for a cheaper price because of the rising cost of employment. With hourly wages and insurance costs, centers are losing out on profits and this allows BFAM to acquire them at a more favorable price. Once these centers fully mature, any revenue generates is profit of the company.

• Overseas Expansion – With the acquisition of Asquith, Bright Horizon operates more than 300 of its 1000 centers worldwide in the U.K. The company plans to continue purchasing center in the U.K. as the demand grows. In 2006, the U.K. government instituted a ten-year plan to make child care more accessible and more affordable for all parents. Additionally, in 2005, the Netherlands government added a child care tax credit for families with working mother, encouraging more women to back to work and increasing demand for child care. As a result, with the government backing, more parents are willing to purchase child care because it allows them to go work and it is subsidized.

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• Consistent Annual Tuition Increases: Bright Horizon has consistently raised tuition by 3-5% for the last 15 years. They target price increases 1% more than their cost increases. This is possible with their 97% retention rate and strong client relationships.

• Increase in clients: Bright Horizon focuses on providing its services to companies with more than 1,000 employees. There are over 15,000 employers that meet this criteria and the company has over 900 of them. With a 70% market share in the child care market, Bright Horizon is he favorite to provide child care services to these companies. As a result, Bright Horizon still has the ability to capture more of the market.

Pro Forma

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 Revenue: Estimated revenue growth was calculated using a weighted average of historical growth rates, management guidance, industry growth rates, analysts’ estimates and student estimates. Revenue growth over the past eight quarters has averaged 5% quarter over quarter. Company guidance estimates 2016 Q4 revenue will be lower as a result of foreign exchange headwinds. The industry is expected to grow under the Trump administration if Trump makes good of his plans to give companies tax incentives to increase child care spending.
 Cost of Revenue: Cost of revenue was based on management guidance and the company’s historical average over the past eight quarters. The cost of revenue has averaged 76%. This cost is expected to stay the same.
 Operating Expense: Operating expenses were estimated using company guidance and the historical average of percentage of revenue over the past eight quarters. The historical average over the past eight quarters has been 12%. Management’s guidance estimates operating expense may change slightly as employee salaries may increase and they may employee more staff as a result of an increase in enrollment. This will allow the company to keep its student to teach ratio of 5:1.
 Earnings per Share Growth: Earnings per share was calculated using the pro forma net income and basic weighted average shares outstanding estimates. This was done to keep estimates consistent with those of revenue growth and expected expenses, resulting in an estimates earnings per share growth rate of 9%.
Valuations In this section, I estimated the fair value of Bright Horizons’ stock. It should be noted that all data was derived from historical company data, company specific events and pro forma.

Franchise Model: The Franchise model incorporates the company’s ability to repeat its business model (at a lower cost). This model is a suitable valuation because Bright Horizon can repeat its business model with little cost and risk being taken on. Bright Horizons’ business model can easily bring their services anywhere with little risk.Using a Profit & Loss model, which accounts for 60% of the company’s total revenue, the client funds the start-up costs for centers, but Bright Horizon assumes ownership in exchange for discounts on employee’s packages. For this model I choose to use a required rate of return of 14%, a ROE of 14.83%, and future growth at 5%. This found a fair value of $56.73, which is 20% undervalued.  Growth Duration Model: Bright Horizons has positive earnings, so I used a growth model to compute a fair value P/E based on the valuation of a competitor and the industry. Since Bright Horizon is the first daycare company to go public, I compared earnings to NORD, a K-12 private education company as well as the education service industry. Using an annual growth rate of 9%, and industry dividend yield of 1% I found a fair value a $51. Average Fair value: Using the figures from the above valuation methods of $56.73 and $51, I estimate that the average fair value price of Bright Horizon is $53.87. With a current price of $71.12, this means that the company is overvalued by 24%.  Forthcoming Risks

 Debt: Bright Horizons has taken on debt in order to grow their business through the opening of new centers, and the acquisitions of other daycare providers. At the end of 2015, the company had $905.7 million in  long term debt and $1.43 billion in total debt. This could limit the ability of the company to obtain additional financing for further expansions. As a result, this could lower the company’s ability to acquire smaller companies, which as added 2-3% to their revenue quarterly. Furthermore, with uncertainty in the U.K. and the company having missed earnings as a result of foreign exchange headwinds, I expect that this uncertainty will continue to affect the company’s revenue projections.
 Failed Acquisitions: Bright Horizons has a proven track record of selectively adding new centers through acquisitions. They target the center that they believe will generate revenue, but more importantly make it through the accreditation process and transition to Bright Horizons programming. With an acquisition, there is some risk that new centers won’t be able to make it through the process. On average, Bright Horizons has to close 10% of the centers they acquire. Additionally, if the centers they acquire take longer than expected to mature or become profitable, the company will lose out on potential revenue. Therefore, if they complete a purchase and have to close down a significant portion of the new center, they will be wasting capital and debt.
 Insider selling: Within the last year, the company’s insiders has made a plethora of transactions all selling shares of the company. Each transaction totaled executives of the company to sell thousands of shares and significantly reducing the amount of shares held within their portfolio. Furthermore, majority of the trades were made by exercise of derivatives, which means they exercised their option to purchase shares at a price lower than market value but sell at market value to make a huge return. So if the executives are selling the stock and not buying, then we should buy either.
 Foreign Exchange Headwinds: This last quarter the company missed revenue and earnings per share estimates. From the company’s perspective, this was largely attributed to foreign exchange headwinds. Particularly because of the strong dollar. The dollar currently is at a 15 year high and is 10% stronger. With around 20% of Bright Horizon’s revenue coming form the U.K. and Europe, the 10% increase in the dollar divided by the 20% share of revenue the company claims from Europe, results in a 2% loss. Add this to the 1% the company already accounts for foreign exchange headwinds and you arrive at the 3% miss in revenue and earnings per share. Additionally, a factor to be worried about is why the company went into the U.K., which is because the government had made a strategic move to increase child care spending. In other words, the government subsidized child care spending to a certain amount. This program was intended to last from 2006-2016. With Brexit and a new government, it is not certain that the government will continue the program and with Brexit certain companies may drop the program or move locations.

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